Sophie Brookes: Great. I'm sure that's right. I'm sure people will think that.
I always think it's a bit of a funny concept, really, a company buying back its own shares. So it's basically paying money to a shareholder in return for the company shares, and those shares are then usually cancelled. We tend to talk about share buybacks or purchase of own shares. They both mean the same thing.
Maybe before we dive into the procedure and those strict legal requirements that you talked about, can you explain why a company might decide to do a buyback?
Imogen Cox: More often than not, we will see one where a certain shareholder is exiting a business, and other circumstances can include, for example, returning surplus cash to shareholders.
Sophie Brookes: Okay. That tends to be, I think, the situations we come across it with private companies.
I guess for public companies, they might be carrying out a buyback as a part of an exercise to increase the earnings-per-share metric. So you end up with the same earnings, but you've got fewer shares in issue. So post the buyback that would just, from a maths perspective, mean that your earnings-per-share has increased and earnings-per-share is a key valuation measure for a company with shares traded on a market. I guess for public companies as well, it can increase the share liquidity, so providing an exit for those that want to sell and helping support the share price and stimulating desire for shares in the company. That's some additional reasons why a public company might do a buyback.
The statutory rules about a buyback are slightly different depending on whether the buyback is taking place on a recognized investment exchange, so a sort of a public company, perhaps buying shares back through London Stock Exchange, or what's called an off-market purchase, so a purchase that isn't taking place through an investment exchange. So just a buyback, perhaps from an individual by a private company.
Because of that difference, the one we're going to concentrate on today is that buyback by a private company buying shares back from an individual shareholder. So, Imogen, tell us what are the key requirements there that we need to look out for?
Imogen Cox: The first one that I'm going to list is the one that I think is often missed, and that's that the buyback itself must be approved by the shareholders of the company in question, and there are specific rules about how that approval is given, which we'll go on to later.
The second key consideration is that the consideration itself must be payable by the company from distributable profits. There are some other options available, which can be utilized in certain circumstances as well.
Finally, the consideration must be paid on completion of the buyback.
Sophie Brookes: Great. Okay. Let's look at the first one of those that you mentioned, so that's about shareholder approval and, as you say, that can sometimes be overlooked. So how does that shareholder approval get given?
Imogen Cox: That's usually given by an ordinary resolution, which essentially means that over 50% of the shares in the company that have attached to their voting rights, over 50% of those votes need to be used in order to approve the buyback. It used to be that a special resolution, which is 75% of the votes, was required, but this changed in April 2013.
So the approval must be given before the buyback contract is entered into, or else the contract must be conditional on getting that approval. The members whose shares are being acquired should not vote on the resolution, and if they do so, the resolution is ineffective if that member with those voting rights results in the 50% being achieved.
Sophie Brookes: That's right. And if only a portion of the member shares are being acquired, then they shouldn't vote on a show of hands because that would be almost like them voting all of their shares. But on a poll, they can vote in respect of the shares that they hold, which are not being bought back by the company.
When we're talking about shareholder approval here, so how is that given? Because it could be a written resolution or a general meeting, is that right?
Imogen Cox: Yeah. If a written resolution is passed, then the member whose shares are being bought back is not eligible to vote, so the written resolution doesn't need to be sent to them and probably shouldn't be sent to them.
With the resolution that does get sent to the voting shareholders, a copy of the buyback agreement itself should be sent with that resolution. Or if the agreement is not in writing, then a memorandum setting out the terms should be sent to the shareholders at the same time.
If the resolution has been passed at a general meeting, the member shouldn't vote on a show of hands, as Sophie said. But if only some of the shares are being bought back, they can exercise their voting rights attached to other shares on a poll.
At a general meeting, the buyback agreement must be available at the registered office for 15 days before the meeting so that any shareholders that are being asked to vote on that particular arrangement can view it. This means that the general meeting won't be able to be held on short notice. So if the buyback needs to be dealt with quickly, it's just this, a written resolution is used instead.
Sophie Brookes: That's right. I've always thought it was a funny quirk there about the sort of interplay between those rules. If you've only got a single member, a single shareholder, and the company is buying back a portion of that member's shares, then you can't do it by written resolution because they're not an eligible member in relation to that resolution, so you have to hold a general meeting. But because the buyback agreement has to be on display for 15 days before the meeting, you can't hold that general meeting on short notice. So you end up having to have a meeting of one shareholder and having it on 15 days' notice, which I always think seems a bit unfair. You could probably get around it possibly by using the geomatic procedure to cure a defect in the internal procedure where all the shareholders unanimously agree to that. Then, in this case, you'd only have one shareholder, but I was thinking it's a bit of an odd interplay, that one.
Okay. That's the first requirement that you told us about relating to shareholder approval, so let's move on now. The next thing you talked about was in relation to paying for the shares. Can you explain the restrictions on the funds that can be used for that?
Imogen Cox: The consideration can be any amount agreed between the shareholders selling their shares and the company, but it generally must come from distributable profits that are available at the time. So just like when you pay a dividend, that would also typically come from distributable profits. So if there was a dividend block caused by negative distributable reserves, you also wouldn't be able to do a share buyback.
In some circumstances, the consideration can be paid out of proceeds of a fresh issue of shares made with purposes of financing the buyback. Private companies can also fund the purchase out of capital, but there are additional procedural requirements that are designed to protect the company's creditors.
Finally, small purchases, which can be up to £15,000 can be funded out of cash.
Sophie Brookes: Great. So there are a few options there, but there are restrictions, I suppose, is the key thing about where you can finance the buyback from. As you say, the general rule is that it comes from distributable profits, and that's where we see most of the buybacks being funded.
I guess one thing just to point out here is what we're talking about is sort of the relevant accounting requirements for funding the buyback in terms of the actual cash consideration that's paid, then that could come from available cash reserves or via a bank loan, but it's the accounting requirement. You have to have available distributable profits to cover that consideration.
You also mentioned I think, that the consideration has to be paid on completion. Can you explain, talk us through what that means in practice?
Imogen Cox: This would generally mean that the full amount needs to be paid to the shareholder in cash at the time when the shares are bought back. So you couldn't defer part of the consideration or pay the consideration in instalments and, equally, you can't use non-cash consideration.
If, however, there are amounts owed by the shareholder to the company, it is possible to set off the consideration payable to the shareholder in respect of the amounts owed by the shareholder to the company. It is because a set-off of a defined amount is equivalent to payment in cash.
We said previously that you can't have deferred consideration, but it also may be possible for a shareholder to loan part of the consideration back to the company. You do, however, need to show the money initially moving from the company to the shareholder and back again. So accounting entries to document the movements aren't enough because that wouldn't be construed as payment on completion. In addition, the loan back can't be a sham. So it would need to bear a commercial rate of interest and also be formally documented as well.
Sophie Brookes: Great. Okay. You've talked us through the main requirements that in terms of approval from the shareholders, consideration coming from distributable reserves, and also that the consideration has to be paid on the completion of the buyback. Are there any other requirements, any other rules in relation to a buyback that we just have to watch out for?
Imogen Cox: Yeah, there are a few more. The shares that are being bought back have to be fully paid. So shares, which are near or partly paid at by a shareholder where the shareholder still owes money to the company for those shares, those shares wouldn't be capable of being bought back. After the buyback occurs, there must be at least one non-renewable share in issue, and this is essentially to make sure that the company doesn't end up without any shares in issue at all.
So there is no restriction or prohibition on purchasing own shares in the company's articles, but before 2009, the articles had to contain a specific power authorizing buyback, but that's fine, as long as there is no restriction or prohibition in the articles.
Sophie Brookes: Great. So you still got to check your articles, but rather than looking for a specific authorizing power and sort of a positive thing, you're looking for a negative, making sure there isn't any kind of restriction or prohibition.
Right. Great. We've gone through all the rules now, so we know the sort of framework within which we've got to operate for a buyback. Let's talk practicalities then. What documents are going to be required?
Imogen Cox: Ordinarily, you'd have a buyback agreement between the company and the shareholder. If there isn't anything written down then, as we said previously, there would need to be a memorandum of terms, which would go to the shareholders for approval with the relevant resolution.
An ordinary resolution is also going to be needed, either written or passed at a general meeting. Statutory forms would also be needed to record the buyback, and they are to be filed at the company's house.
Sophie Brookes: Okay. What happens at completion then? So what happens when the shares are actually bought back?
Imogen Cox: Often, the shares are cancelled. Stamp duty is also payable on one of the forms that need to be prepared and signed at the time. The relevant form, which is an SH03 initially for the buyback and then an SH06 for the cancellation, in addition to the ordinary resolution, it needs to be filed at Companies House. Then once the shares are cancelled, the statutory books can be written up to show that those shares have been cancelled.
Sophie Brookes: Great. The other thing, I suppose, that happens is because you've bought back some shares and, therefore, the company has fewer shares in issue, the people, the sort of continuing shareholders, each of their percentage shareholdings in the company will ratchet up just because they're holding the same number of shares, but of a smaller total mass. So that might mean that they either become a PSC, a person with significant control over the company, so somebody who's got over 25% of the shares, or they perhaps move through one of the PSC bindings, either between 25 and 50%, 50 and 75% or over 75. So the fact that the company buys back shares from one shareholder could have knock-on effects for the continuing shareholders if they then need to be registered as a PSC or registered as holding a different threshold of shares in the company.
Now, you mentioned at the start that one of the reasons why you thought this would be a good topic is because people often don't follow those rules that we've just discussed that you've just explained to us and that there are some sort of serious consequences if you don't follow that procedure. What are those consequences? What could happen?
Imogen Cox: Well, a failure to follow the rules basically means that the transaction is void. So the person whose shares were being bought back, that person is still the holder of those shares, and the transaction is void.
This can cause a problem for a company, for example on a subsequent sale, because the buyer will be wanting to make sure that they're acquiring the entire issued share capital of the company if that's the transaction that's going ahead. If the buyback hasn't been done correctly, potentially there is a shareholder who is not involved in that transaction that still holds those shares. So they would want to make sure that those shares are within the control of the company, either they've been bought back properly or they've been cancelled before that transaction goes ahead.
Sophie Brookes: Right, and I see now why you said that you often come across these kinds of issues around share buybacks when you're doing due diligence. As part of a due diligence exercise looking at a target company, you're going to be looking at its share capital history, and verifying who the owners of the current shares are because, obviously, that's who the buyer wants to contract with and wants to buy the shares from. So, yeah, I can see that if there's in that history, there's a buyback and it wasn't done properly and it's void, then I can see that it's going to create a problem on a transaction about who actually owns the shares, who should be selling them to the buyer.
What can you do to try and sort that out then, if you come across that kind of an issue?
Imogen Cox: There are limited absolute defensive solutions. One is going to court and seeking a court-approved capital reduction to get rid of the shares, but this is likely to incur additional costs, and it could delay the timescale of the transaction that you're interested in. So it could effectively be a sledgehammer to crack a nut.
The other solution is, well, it involves getting in touch with that former shareholder and, with their consent, either redo the buyback where you follow the correct procedure or doing a solvency statement capital reduction. This route doesn't involve the court so it's easier, but you've really got to get that former shareholder on your side in order for it to be carried out effectively and efficiently.
If the former shareholder had already received consideration for their shares, they would be under the impression that they've already sold their shares so they're unlikely to complain. In addition to that, the court would be unlikely to be sympathetic to that shareholder should that shareholder decide to challenge the capital reduction by way of a solvency statement.
Sophie Brookes: Yeah. Okay. Well, at least there are some solutions there, so that was really good, isn't it? So there are a couple of ways you can definitively sort this out, either by going to the court or if they're traceable, by involving the former shareholder. Then there is something you can do if that former shareholder is not traceable. Let's say when you're doing your due diligence exercise, you discover a faulty buyback that's five, eight, ten even years old, and nobody knows where the shareholder is, so there is something you can do in that circumstance. Although, it's probably not without risk, as you say, it's probably the most pragmatic solution in the circumstances because the former shareholders receive the cash, they think they have sold the shares are not going to complain, and probably on that basis, the court would be unsympathetic if they did try to bring a claim.
That's really useful, Imogen. I hope everybody listening has found that helpful to explain why share buybacks can sometimes go wrong and the consequences and, therefore, why it is a good idea in the first place to actually follow that statutory procedure properly and make sure that you jumped through all the hoops, tick all the boxes, and then it can't be challenged. So thanks very much for explaining all of that.
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