Capital reduction case law decisions and the development of the capital maintenance doctrine in late-nineteenth-century England

Abstract

Incorporation with limited liability enabled companies to ‘lock-in’ their financial capital’ and then invest in the long-term, highly specific investments on which the modern industrial economy would be based. The level of benefit varied from country to country, according to the way that the concept of capital lock-in, or maintenance, was defined in the legal systems concerned.

In the UK, the concept was not well defined in early company legislation and challenges were raised through the courts during the late nineteenth century. Some of these, the ‘dividend cases’, have been quite widely considered in the literature but direct reductions of share capital, or capital reduction schemes, have received far less attention, even though they raised fundamental issues concerning long-term dividend positions, the accounting treatment of accumulated losses, depreciation and asset values and had important effects on the development of the capital maintenance doctrine and on shareholder class rights.

The purpose of this paper is to question whether this literature adequately captures judicial influences on the development of the capital maintenance doctrine in England during the latter part of the nineteenth century, given the limited attention that has been paid to date to the leading capital reduction cases.

Keywords:

• capital reduction schemes
• shareholder class rights
• capital maintenance
• nineteenth-century accounting

Acknowledgements

I would like to thank the Duke of Buccleuch for permission to use some of the Buccleuch papers, Glenn Lang and Selena Kendall of Barrow Record office for help in accessing some of the research materials used in this paper, Chris Napier, Roger Hussey and other participants in the Nineteenth Annual Financial Reporting and Business Communication at Bristol University in July 2015 and two anonymous referees for their comments on an earlier version of the paper.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1. Ribstein has argued that capital lock-ins were also available through the partnership form and that the lock-in was ‘backed by politically influential corporate managers because of its role in underpinning managers power … over the corporate cash’ (2005, pp. 524, 538).

2. See re Barrow Haematite Steel Company (1888) L.R. 39 Ch. D. 582; re Barrow Haematite Steel Company (1900) 2 Ch. 846; re Barrow Haematite Steel Company (1901) 2 Ch. 746; Bond v Barrow Haematite Steel Company (1902) 1 Ch. 353. The company also obtained an Act of Parliament in 1902 that resolved some of the issues concerned; Barrow Haematite Steel Co. Ltd Act 1902.

3. See, for example, the Report of the Sandilands Committee on Inflation Accounting (1975). It has been argued that a distinctive quality of capitalism is its reasoning in terms of return on capital (profit divided by capital) (see Bryer 2000, Chiapello 2007; also Toms 2010).

4. This was clearly expressed in court cases in 1882 and 1887, although ‘for practical purposes, the common law principle has been surpassed by the statutory rules introduced in 1980’ (Armour 2000, p. 365). See also the Companies Acts of 1947–1948, 1985 (Parts V and VIII) and 2006 (Parts 17, 18 and 23).

5. See Trevor v Whitworth (1887) 12 App Cas 409, HL. The issuing of redeemable preference shares became possible under the Companies Acts 1947, 1948, an arrangement extended to ordinary shares by the Companies Act 1981.

6. Blair (2003b, p. 18). See Hope v International Financial Society Ltd (1877) 46 L. J. Ch. 200 regarding the general principle of capital reductions under court supervision. The 1985 Companies Act, s. 142 did later require that a shareholders meeting be called when a company's net assets fell below one half of its called-up share capital.

7. Since October 2008, under the Companies Act (2006), new procedures are available in situations where capital may have been lost that enable private companies to put forward solvency statements signed by directors instead of seeking the approval of the courts. As Edwards points out, however, solvency tests may work satisfactorily in the short-term but fail to maintain the capital of the business in the long-term (Edwards 1989, p. 182; see also Mason 1932, pp. 64–5).

8. Expenses generally caused greater problems although profit measurement issues could also arise over receipts (see Yamey 1941, French 1977, Morris 1986, Reid 1986, 1987a,b, 1988, Edwards 1989, pp. 177–84).

9. See also Verner (1894) in which Lindley LJ made clear the new rule; assets were to be divided into two classes, fixed and circulating, and only declines in the value of the latter needed to be allowed for in calculating the size of the dividend fund. The fact that depreciation on fixed assets could be ignored was confirmed in re Kingston Cotton Mills Co. No. 2 (1896) 1 Ch 331. Later, Ammonia Soda Company v Chamberlain (1918) 1 Ch. 266 took decisions on unrealised increases in the value of property (Yamey 1941, pp. 280–4).

10. See Ardern and Aiken (2005, p. 48), French (1977, p. 315) and Edwards (1989, p. 180).

11. The successive Gilchrist-Thomas, acid steel, Siemens and basic steel processes (see Andrews and Brunner 1951, Roepke 1956, pp. 56–61, Carr and Taplin 1962, pp. 94–7, 123–8, Birch 1967, pp. 353–86, McCloskey 1970, p. 448, Floud 1994, pp. 3–4, 15, Abe 1996).

12. See Cottrell (1980, p. 86). By 1915, these proportions would be 30.1% and 40.7%, respectively (Cottrell 1980, p. 164; see also Jefferys 1946).

13. ‘Interest is not an apt word to express the return to which a shareholder is entitled in respect of shares paid up in due course and not by way of advance. Interest is compensation for delay in payment and is not accurately applied to the share of profits of trading’; Mr Justice Farwell, Bond v Barrow Haematite Steel Company (1902).

14. See Mayson et al. (1996, p. 153), Ferran (1999, pp. 323–4) and Pickering (1963).

15. It was registered as the Barrow Haematite Iron and Steel Co Ltd, although it generally traded as Barrow Haematite Steel Co Ltd; NA, BT31/1126c/44942–44944, BHS company papers. The development of these businesses was behind the spectacular growth of Barrow between 1845 and 1881 (see Pollard and Marshall 1953, Pollard 1954, 1955, Marshall 1958, Cannadine 1977).

16. See Cannadine (1977, pp. 94–6) and Pollard (1955, p. 218). The Duke also received royalty payments on a deposit of more than eight million tons of best quality haematite ore that was found on his land in 1851, the second largest ever find in the UK, and was used extensively by BHS (Marshall 1958, pp. 202–3).

17. The main iron ore deposit they owned contained more than eight million tons of best quality haematite ore (Barrow Records Office, BD HJ 163/3/1, Draft deed of agreement Barrow Haematite Steel Company Ltd (BHS) and Schneider and Hannay 1864; First AGM of BHS, 29 March 1865; National Archives of Scotland, Buccleuch papers, GD 224/144/5; Marshall 1958, pp. 251–7, 343, Carr and Taplin 1962, p. 29).

18. The main data were obtained from: Barrow Records Office, BD HJ 163/3/1, Draft deed of agreement between BHS and Schneider and Hannay and the National Archives, BT31/1126c/44942–44944, Company files BHS for 1864; the National Archives of Scotland, Buccleuch papers; GD 224/144/5 BHS annual reports for 1865–82 and the Guildhall Library, London, annual reports filed with Stock Exchange, BHS for 1883–1902.

19. See Pollard (1955, p. 215), Pollard and Marshall (1953, p. 122) and Carr and Taplin (1962, p. 84). See Table 3 col. 1 1871–1873 ((19.3+20.4+27.3)/3); Table 3 col. 2 1871–1873 ((24.0+25.9+34.2)/3).

20. See Cannadine (1977, pp. 84–5, 94–6) and Pollard (1954, 1955).

21. See Birch (1967, p. 353); see also Pollard (1955, p. 216) and Carr and Taplin (1962, pp. 95, 123–8).

22. See Table 3 col. 1 1885–1887 ((0.9+1.2+1.3)/3).

23. Annual report to 24th AGM of BHS, 14 March 1888, Guildhall Library, annual reports filed with Stock Exchange.

24. Annual report to 24th AGM of BHS p. 4, 14 March 1888, Guildhall Library, annual reports filed with Stock Exchange. In fact, in the earlier case, the articles of the company contained a power to reduce the capital at the point in time when the preference shares were issued and could therefore be seen as part of an agreed bargain. At BHS, the capital reduction was based upon a general entitlement in section 9 of the Companies Act 1867 and the subsequent amendment of the company's articles by special resolution in 1885, on which the preference shareholders could not vote; see re Barrow Haematite Steel Company, Chancery Division, 1888. The passing of the resolution in 1885 was itself caused directly by the situation at the collieries; the annual report to the members meeting in March indicated that counsels advice was being taken as to ‘how best to deal with the capital loss' concerned; Annual report to 21st AGM of BHS pp. 3–4, 16 March 1885, Guildhall Library, annual reports filed with Stock Exchange.

25. They also argued that the lack of available profits was partly due to imprudent ordinary dividend payments in 1873–1883 totalling £1,043,000 (see Table 2, col. 7; although none had been had been paid in 1884–1888, when the arrears of preference dividends had reached £124,000) and that the ordinary shares had been increased by £500,000 through bonus issues out of profits in 1867–1874, without which there would be ‘no necessity for the reduction of capital’ (see Table 2, col. 8).

26. The ordinary share capital was reduced by £375,000 and the preference shares by the remaining £134,425. Ex post, the preference shareholders came out of the 1888 reductions quite well; in 1888–1899 they received dividends of £330,000, which greatly reduced the arrears of their dividends, whereas the ordinary shareholders received only two small dividends, each of 2.5% (see Table 2, cols 6–7). The returns on capital employed were from 1889–1899 inclusive (see Table 3 col. 1). The rates of return would of course have been even lower had the capital figures not been reduced in 1888. The average annual charge for depreciation for 1889–1899 (see Table 2 col. 2) was £17,700; the average fixed asset book value for the same period was £1,821,000 (see Table 1 col. 7).

27. The capital consisted of £1,125,000 in ordinary shares and £28,275 in 8% and £375,000 in 6% preference shares; annual report to 37th AGM of BHS, 2 April 1901; Guildhall Library, annual reports filed with Stock Exchange.

28. This is still the leading case on the principle that ‘no dividend is payable on a company's shares, even on preference shares, unless and until the company has decided to pay one’ (Mayson et al. 1996, pp. 282–3).

29. See also Lindley LJ in Lee v Neuchatel Asphalte Co. (1889). BHS's article 96 said ‘no dividend shall be payable except out of the profits arising from the business of the company’.

30. Of the two he identified, Professor Marshall's and Lord Justice Lindley's, the first clearly looked to an annual comparison of both fixed and circulating capital. Thus, Marshall said that

when a man is engaged in business, his profits for the year are the excess of his receipts from his business during the year over his outlay for his business; the difference between the value of his stock and plant at the end and at the beginning of the year being taken as part of his receipts or as part of his outlay, according as there has been an increase or decrease of value. (1890, p. 134)

‘Stock and plant’ clearly includes both fixed and circulating capital. Following Mill, circulating capital, ‘fulfils the whole of its office in the production in which it is engaged, by a single use’ whereas fixed capital, ‘exists in a durable shape and the return to which is spread over a period of corresponding duration’ (Marshall 1890, pp. 134, 142). The second, Lindley's, argued that ‘fixed capital may be sunk and lost, and yet the excess of current receipts over current payments may be divided’, as long as the floating or circulating capital was ‘kept up’ (Lee v Neuchatel Asphalte Co. 1889; Verner v General and Commercial Investment Trust 1894).

31. See Parliamentary Archives, House of Lords, Barrow Haematite Steel Co Ltd Act 1902, pp. 4–5. The Companies Act 1862 (25 and 26 Vict. c.89, s.162) did give companies the power to purchase their own shares with statutory authorisation.

32. The ordinary shares and 6% preference shares were written down from £7.5 to £4.5 and the 8% preference shares from £75 to £45, the capital in total from £1,528,275 to £916,965, with the remaining £152,828 (of the £764,138 reduction in assets) transferred from Profit and Loss. The 6% preference shares were to receive a (cumulative) annual dividend of 6% on their reduced capital, with further dividends to be paid at half the rate of any ordinary dividends. The 8% preference shareholders were to receive a (cumulative) annual dividend of 13.3% on their reduced capital to maintain their previous annual dividend amount; annual report to 39th AGM of BHS, 18 March 1903; Guildhall Library, annual reports filed with Stock Exchange.

33. As Marx and others have shown, the distinction is actually rather relative and unreliable; fixed capital also ‘circulates', even if its circulation time is much longer. This being so, it is not difficult to see depreciation charges as a mechanism to estimate the extent to which the ‘fixed’ had become ‘circulating’ and therefore properly chargeable against current revenues. See Marx (1978, Vol. 1, pp 760–1) including the comment that ‘political economy since the time of Adam Smith has confusedly mixed up the determining characteristics contained in these categories [variable and constant capital] with the merely formal distinction, arising out of the process of circulation, between fixed and circulating capital’ (p. 760). See also Vol. 2 (pp. 237–61), including the argument that ‘the peculiar circulation of fixed capital gives rise to a peculiar turnover. The portion of value that it loses in its natural form by wear and tear circulates as a value portion of the product’ (p. 242). See also French (1977, pp. 314–22), Yamey (1941, pp. 280–1) and Bryer (1998), for a discussion of the distinction between circulating and fixed assets and Napier (2015) for an explanation of the Lee case as the survival of aristocratic attitudes to capital and income.