Prior to the Companies Act 2006 (the Act), it was prohibited for a company to buy back its own shares, so the only option available to a shareholder wanting to sell their shares was to find a third party to purchase the shares. Buybacks are now permitted but are subject to restrictive provisions contained in Part 18 of the Act.
What happens when a company buys back it’s own shares
When a company buys back its own shares, it receives nothing of financial value in return. The shares instantly become worthless and are treated as cancelled by the company. In relation to a public company, cancelling shares by a buyback is a way of reducing the number of shares in issue and therefore increases the profit per share.
Share buybacks can also be useful in small private companies. In instances where the directors and the shareholders are one in the same and a serious dispute arises, it is possible that a director will not resign unless his shares are also purchased. The other shareholders may not be able to afford to purchase the shares, so the company arranges to purchase the shares to cut ties with the director.
A company can purchase the shares from its distributable profits. In accordance with s.830 of the Act, distributable profits are a company’s ‘accumulated, realised profits (so far as not previously used by distribution or capitalisation) less its losses’. However, there is a requirement for the shares to be paid upon purchase, so in the event that the cost of the buyback uses up all of the distributable profits, some of the company’s existing share capital can be used, this is known as a buyback out of capital.
The amount of capital to be used is limited to the ’permissible capital payment’ (PCP) or the de minimis exemption. The PCP is not a set amount, but ensures that a company uses its distributable profits and any proceeds from new share issues before any payments out of capital are made.
The de minimis exemption allows a company to purchase its own shares out of capital with cash up to an amount in a financial year not exceeding the lower of £15,000 or the value of 5% of the share capital. The aim of this is to allow shareholders to authorise small buybacks without being subject to the PCP provisions.
Conditions for buybacks
Both buybacks out of distributable profits and buybacks out of capital require there to be no prohibition of the transaction in the company’s articles of association and for the shares to be fully paid. In addition to this, there are additional conditions for buybacks out of capital that the directors make a statement that the company is solvent, with an auditor’s report annexed to the statement, and will remain so for the next 12 months. A buyback out of capital will also require the shareholders to pass a special resolution in order to approve the transaction, whereas, buybacks out of distributable profits only require an ordinary resolution to be passed.
A buyback out of capital increases a company’s risk of becoming insolvent. The company would own less than the original investment which is available to pay creditors and so the creditors are likely to receive less money than before the buyback had occurred. If the insolvency takes place within the 12 month period of the statement of solvency being made, the directors may be required to contribute to the financial losses of the company and subject to criminal sanction.
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