Vol 12 (2015) - Issue 5

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The Concept of Legal Capital Does Not in Principle Provide Effective Protection to Creditors

Despite the UK legal capital requirements for companies to protect the interests of creditors, it is still not being safeguarded absolutely. This article considers the protection offered for creditors under UK legislation and discusses whether the existing rules can guarantee creditors’ interest effectively and how the legal framework can be improved.

1. Background
The capital requirements regulate corporate activity by prescribing the process of shareholders’ capital investment. These rules govern how much capital can be raised by shareholders, how much can be invested in the company and the level of return to the shareholders. Companies are able to finance themselves in two ways, namely: (i) by issuing shares whereby investors become shareholders; or (ii) they borrow loans from creditors. It is still common practice for creditors to require various levels of guarantee in return for their investment. As company members, shareholders are in a better position to benefit from the company’s investments. For instance, they could overrate the company assets and take a more risk-prone approach to business without consideration for their duties, or they could pay dividends and draft the investment policy of the company.
As such, a potential conflict of interest can arise between shareholders and creditors. On one hand, shareholders control the operations of the company through general meetings of the board of directors. A flawed decision of the board of directors which results in the insolvency of the company cannot protect the creditors’ interests. On the other hand, creditors can require the company to hold dividends, repay loans early, or encourage it to invest with a more risk-averse attitude. However, the rules for the protection of creditors’ investments are applied retrospectively, when the company is near insolvency, or is insolvent.
In this regard, under the existing systems of corporate regulation, the benefits to shareholders conflict with provisions to protect creditors’ interests. This conflict of interest should be settled by the legal capital rules. Under the current corporate regulation, the strategies for the protection of creditors are: (i) mandatory disclosure rules in relation to financial performance; (ii) detailed legal capital rules for the maintenance of a company’s capital; and (iii) solvency-based standards underpinned by personal liability of the directors. Fortunately, more information is now included in the filing of annual company reports, which includes the status of the company’s accounts and, in the case of a PLC, its disclosed obligations. This can help creditors to determine their decision to lend capital and they may have contractual rights preventing assets diversions, or control rights from fixed securities. However, the method of protection for creditors before and after the loan is given is different depending on the covenant events or defaults. This information discrepancy can lead to many advantages for one party whilst being costly to the other. The necessary risk requires creditors to be compensated in advance especially considering the interest rate and the ranking by repayment. Therefore, the concept of capital rules and how efficiently they protect the creditors’ interests still needs to be examined more closely.