Sharman Inquiry preliminary report sets out a classic description of the relationship between a limited liability company, its shareholders and its creditors
The Sharman Inquiry on “Going concern and liquidity risk” published its preliminary report today, as we discuss in this post. Contained in the report is this summary of the birth, life and death of a limited liability company:
“A limited liability company starts life with assets contributed by its shareholders. They represent its capital. The shareholders do not have an absolute right to claim back these assets except if the Courts agree (usually on liquidation of the company). This is a key term of the contract that the company of shareholders enters into in exchange for its limited liability status.
In return for their capital contribution, the shareholders obtain two conditional rights (see below). The first is the right to appoint themselves or their agents ‐ the directors ‐ to control the company primarily in their interest. The second is the right to enjoy the benefit of the companyʹs present and prospective assets, after first allowing in full for the claims of all others (creditors) over those assets (a residual interest). Furthermore, the shareholders are not required to contribute further capital if losses consume the capital they have already contributed. Excess losses fall on the creditors. In effect, shareholders have the right to take profits but to leave excess losses for the creditors to bear.
Creditorsʹ claims therefore have priority over the shareholdersʹ right to enjoy the benefit of the assets. However, when the company is profitable, they have no interest in those assets beyond their claim but they bear the risk that excess losses may limit the companyʹs ability to meet their claims in full (credit risk) as well as the risk that the entity will not be able to settle their claims when due (liquidity risk).
This asymmetry creates a moral hazard for directors acting primarily in the interests of shareholders ‐ they might take greater risks than they would otherwise, in the knowledge that, whilst resulting gains would benefit the shareholders, their exposure to resulting losses would be limited. There are five principal sources of protection to mitigate this risk for creditors:
a. The directorsʹ fiduciary duties require them to promote the success of the company having regard to the likely consequences of their decisions in the long term and to the impact of its operations on the community and the environment and there are sanctions for inappropriate behaviour. There are also significant penalties for directors who continue to trade whilst insolvent. These measures aim to provide incentives for directors to manage the companyʹs affairs primarily in the interests of shareholders, but also with a view to protecting the interests of creditors and others.
b. The capital of the company provides a buffer to absorb losses that would otherwise damage creditorsʹ claims. Once contributed, capital cannot be withdrawn unless the courts, having regard to the interests of creditors, approve it or the company is liquidated and all creditorsʹ claims are first met.
c. The shareholdersʹ rights to control and to enjoy the benefits of the companyʹs assets are conditional at all times on the company:
- having the capacity to meet the aggregate claims of others over its assets (a capital adequacy or solvency condition); and
- being able to meet each claim over those assets at such time as each claim is due to be settled (a liquidity condition).
Claims are taken into account for this purpose whether they are contingent or absolute and whether they are due immediately or at some time in the future. If at any time these conditions do not prevail, the company is insolvent. A critical consequence of insolvency is that shareholders lose the right to control the company primarily for their benefit through the appointment of the directors. Control passes to an appointed insolvency practitioner who exercises it primarily for the benefit of the companyʹs creditors.
d. Creditors have and can establish legal rights. In the first instance, they will seek compensation for the risk they take by demanding a commensurate return. They may seek credit insurance. They could even seek to counter their asymmetric downside risk by sharing in the upside risk of the business under an option to convert their claims to an interest in the capital of the company at a fixed price. They may also seek to establish a range of other contractual terms to mitigate or enable them to better manage their credit and liquidity risks if these risks materialise. Such terms may grant the creditor: access to inside information to monitor its risk; security or collateral rights over assets; or triggers (covenants) to accelerate the settlement of their claims, to enhance their returns, or to give them greater control when liquidity or credit risks are heightened. Creditors who provide resources may reserve title to the resources they contribute. This would enable them to withdraw those resources in the event of their claims not being met when due.
e. Creditors may have the benefit of some specific or general protections under laws or regulations. For example, depositors are protected from bank failure under the Financial Services Compensation Scheme; and the establishment of regulators with the power to intervene to limit the risk of discontinuities in service in systemically important industries such as financial services and utilities provide a measure of general protection.
The ultimate risk to the going concern status of an entity is the risk of the entity not being able to pay all of its fixed claims (liabilities) out of its assets (solvency risk). The tipping point arises when the aggregate value of the assets is less than the aggregate value of the fixed claims (insolvency) – beyond this point there is no value in the claims of equity holders and rationally they would no longer support the entity. Beyond this point, the assets would therefore be liquidated to repay the fixed claims as far as is possible.”
UPDATE 14 June 2012: The Sharman Inquiry has now published its final report, as we cover here.
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