Tom, Dick and Harry are in business together in the form of a legal partnership. The business having developed somewhat, they are now keen to incorporate their business into a limited company. This will undoubtedly have benefits for the traders, although there are of course certain ramifications of which they should be aware which will be dealt with after a discussion of the benefits of incorporating.
The correct choice of business medium is a crucial decision for any business. It will affect how the business trades, the liability of those running the business (in their guise of partners or directors) and the liabilities of the business itself for taxation, for example, in the case of a company. Perhaps the most significant concern for Tom, Dick and Harry, is the risk of capital that is associated with any business. The overwhelming benefit in this context of forming a limited company over remaining as a partnership is that a company will carry only limited liability. This means that the owners of the company (that is, Tom, Dick and Harry, assuming they remain as directors and become shareholders) will only be liable for the amount of unpaid shares in the company if the company were to become insolvent or even bankrupt. In other words, they can choose the amount which they are willing to pay into the company (which does not have to be paid up front), and this is the total amount for which they would be liable should the company ever be wound up. This can be contrasted with the situation under a partnership where the partners would be both jointly and severally liable for the entire value of their trading losses. This means a partner could lose any property that he owns.
The beneficial effects of this arrangement would be limited, however, in a number of situations. If Tom Dick and Harry were to risk everything in the business, that is, if they invest all there assets in the business, then they would still lose it all if the company were to become insolvent. Secondly, it is often the case that when a company comes to borrow money for business development, and particularly where the company is relatively new and unknown to the banks, that the lenders will demand personal guarantees for the value of the loan on top of the normal contractual and security relations with the company. These would, obviously, override the limited liability associated with the company. As business is good for Tom, Dick and Harry at the moment, however, this would not appear to be an immediate problem.
A further issue to be considered when deciding whether to incorporate as a company is the expense involved. While these are not extortionate, they are, at least, significant, and should be duly considered by Tom, Dick and Harry. Unlike a partnership, a company needs to be registered, which incurs fees itself. There will be legal fees payable to the solicitor who draws up the new company’s memorandum and articles of association (together, the constitutional documents of the company), which are essential, and outline the aims, methods, and rules of the company’s business life.
A similar issue of expense and complexity that will be incurred by a company as opposed to a partnership relates to the accounts of the company. While all businesses, including partnerships, obviously wish to keep accounts, the requirements for accounting for companies are more particular and complicated. The accounts need to be more detailed, and show certain information in a particular way. Furthermore, because companies are subject to more rigorous regulation, the accounts of a company will need to be audited annually by an independent qualified accountant. This, of course, will incur higher accountancy costs that would be expected for a partnership. The company will also be required to complete an annual return and pay a fee on filing it with the Registrar.
A company is subject to certain rules and regulations relating to its operation and management, which are statutorily set out in the Companies Act 1985 (subject to be overhauled when the current Company Reform Bill makes it through Parliament). An example of this is the requirement that a company must have at least one director and one secretary. It is usual for the first owners (Tom, Dick and Harry) to become the first directors and / or secretary. These officials will have certain obligations relating to duties owed to the company, and in respect of items that need to be completed and filed with the Registrar of companies at Companies House.
An important consideration to take into account is the flexibility of a company to change its internal structure if and when circumstances require it. Such a change would normally involve and require an alteration to the company’s articles of association. This would require, under the Companies Act, a so-called ‘special resolution’, which equates to 75% of the shareholders. In the case of Tom, Dick and Harry, if they were to remain the only shareholders, any such decision would, of course, have to be unanimous. If any conflict is predicted, this will have to be a consideration for the parties. It is worth noting that this requirement is no more stringent than that required for altering a partnership agreement, which requires the approval of all partners. If a conflict were to arise between the directors of the company, the other shareholders would be able to remove the troublesome director by way of an ordinary resolution.
Finally, the legal status of a company differs significantly from that of a partnership. A company is seen as a separate legal person, which means it can contract and be held liable in its own name. This has ramifications for the liability of the directors, and is generally seen as a benefit of a company. Only a company (and not a partnership) can create floating charges over their assets. This is significant when it comes to raising finance by way of granting security. It will probably be easier for a company to raise the requisite finance than for a partnership to do so. It is also significant (or may be) that an unlimited number of people can become members of a company, whereas a partnership is limited to twenty partners. If and when the company grows and develops, it will be in its interests to be unlimited in the number of new members it can obtain.
In this scenario, there are a number of developments which will impact on the running and management of the business. Each development will be taken in turn.
Firstly, the sale of the company’s property to Dick’s sister, Fanny in 2006 will be problematic. There are three principal areas of concern. Firstly, the company’s articles of association expressly prohibit the sale of company property without a special resolution of the members. As was mentioned above, a special resolution requires a 75% majority, or in this case, as there are only three members, a unanimous vote. There is a course of action that the directors can take, however, after the event, that could ratify the sale of the company property. They will simply need to call an extraordinary general meeting, following the correct procedure of course, and pass a special resolution either to ratify the sale of the company property to Fanny, or else to alter the articles of association to allow for such sales in a more general context.
The value and size of the property that is sold to Fanny will be significant in the second area of concern for the company. Under section 320 of the CA, ‘a company shall not enter into an arrangement whereby a director of the company or its holding company, or a person connected with such a director, acquires or is to acquire one or more non-cash assets of the requisite value from the company…unless the arrangement is first approved by a resolution of the company in general meeting.’ The reason the value of the property that is transferred to Fanny is significant is because of the existence of the concept of ‘requisite value’, which is set down in section 320(2). This states that the requisite value for a non-cash asset is £100,000 or 10% of the company’s asset value. If the property is of this value or greater, then, it will be of the requisite value, and will contravene section 320. The fact that Fanny (the purchaser) is the sister of a director classes her as a ‘connected person’. As such, she breaches the section 320 prohibition.
Finally, the gross undervaluing of the property in the company’s sale of it to Fanny will be a problem, as it is likely that this will breach section 339 CA in the case of the company becoming insolvent. Were this to happen, the insolvency practitioner would likely deem the transaction to be voidable, and the asset would be brought back into the pool of the company’s assets in order to satisfy the creditors. This would occur if the transaction occurred within 5 years of the presentation of the petition for winding up (because Fanny, again, is an ‘associate’ of the transferor). Under section 238 defines a transaction at an undervalue as one where a company makes a gift to any person and receives either no consideration for it or consideration worth significantly less than the consideration provided by the company. This transaction clearly qualifies as such. It will be deemed to be set aside if insolvency proceedings commence within two years of the transaction.
Each of the directors’ decisions will now be addressed. They decide, firstly, to enter a contract with Oui Ltd. This is not, of course, a problem in itself, apart from the fact that Tom is a director of Oui Ltd. Firstly, if entry into the contract was ratified by an ordinary resolution in the company, Tom would not have been able to vote on it under section 94, because he has an interest in it. If Dry Ltd have adopted Table A articles of association, this would be confirmed by article 94. The company should have kept a register of its directors, which lists the interests and other directorships of all its directors (under section 288 CA), which would have detailed Tom’s directorship of Oui Ltd. Furthermore, section 317 CA requires Tom to have declared his interest in the proposed contract with Oui Ltd at a board meeting of Dry Ltd. He should have given general notice of his directorship.
The company issues a further 10,000 unpaid shares to a third party to fight off a takeover bid. This should not create a problem so long as the company’s articles of association give the directors power to issue shares. This in turn is dependent on the company having a sufficient amount of unissued authorised share capital. If it does not, a special resolution will need to be passed to increase this authorised share capital, before passing a further resolution allowing the issue. The powers of the directors in this instance are regulated by section 80 CA. Furthermore, the company must, under section 89, give consideration to rights of pre-emption to existing shareholders. As the directors are the only three shareholders, this should not be a problem, but it would mean they had to wait 21 days before issuing the new shares.
The resignation of David and his formation of Whip Ltd, which obtains the contract from Pop Ltd might breach his director’s service contract with Dry Ltd. It is usual for such contracts to contain a clause prohibiting former directors using their business contacts within a certain time of leaving the former directorship; a non-solicitation clause. This would protect Dry Ltd’s business links.
Given Harry’s age and his mental deterioration, the company will be able, if it has the heart, to remove him from office following the procedure for removal of directors set down in section 303 CA, which requires an ordinary resolution to be passed. Harry may be able to claim damages for his removal from office under this procedure.