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Date: 3 March 2008

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Corporate Briefing - Companies Act 2006: The repeal of the statutory prohibition of financial assistance for private companies

Following a recommendation of the Company Law Review, the statutory rule which prohibits a private company giving financial assistance for the purpose of the acquisition of shares in itself or a private parent company, or for the purpose of discharging or reducing a liability incurred to acquire such shares, has been repealed with effect from 1 October 2008. 

This statutory prohibition made its first appearance in the Companies Act 1928.  It was designed to put a stop to certain dubious transactions which had taken place where  companies had been acquired with the use of their own assets without regard to the interests of their creditors.  The prohibition has been modified in successive statutes.  The most recent modification was in the Companies Act 1981 which introduced the whitewash procedure for the first time.  This enables private companies to provide financial assistance for the acquisition of shares in themselves or their private parent company subject to complying with certain requirements designed to protect shareholders and creditors.

The statutory prohibition is retained in the case of public companies because of the need to comply with article 23 of the Second European Company Law Directive which (subject to certain limited exceptions) prohibits a public company advancing funds, making loans or providing security with a view to the acquisition of its shares by a third party.  So the prohibition will continue to apply (subject to certain exceptions) to the giving of financial assistance by a public company for the purpose of the acquisition of shares in itself or a parent company (whether the parent is a public or a private company) and also to the giving of financial assistance by a private company for the purpose of the acquisition of shares in a public company parent.

To the extent that the statutory prohibition is repealed, a transaction which would have contravened the prohibition will no longer attract criminal sanctions or automatically be void. Nevertheless, although a private company will be released from this prohibition with effect from 1 October 2008, it will still be necessary for the directors of the company to have regard to their duties when authorising a transaction involving the giving of financial assistance.  In particular, they will need to decide if the transaction is consistent with their duty to promote the success of the company for the benefit of its members as a whole (see further Claire Mowbray’s article).  Furthermore, if the company is on the verge of insolvency, the directors will be in breach of their duty to the company's creditors if the giving of the financial assistance is not in the interests of creditors. If the directors act in breach of their duties they may be held accountable for any loss suffered by the company or its creditors.

It must also be borne in mind that a transaction which would have constituted financial assistance may still be unlawful if it contravenes another mandatory provision of the Companies Acts. For example, if the transaction involves the making of a loan to a third party to acquire shares in the company and the third party is unlikely, from the outset, to be able to repay the loan, the company would need to make a provision for a bad or doubtful debt in recognition of the borrower's lack of creditworthiness.  If the creation of this provision would result in a loss of any of the company's capital the giving of the financial assistance would constitute an unlawful reduction of capital under the principles laid down by the House of Lords in 1887 in the case of Trevor v Whitworth.

The impending abrogation of this statutory prohibition as it affects private companies is to be welcomed.  Too often the prohibition has proved to be an obstacle to a perfectly reasonable transaction which does not prejudice the company's shareholders or creditors.  Furthermore the prohibition has given rise to a considerable amount of litigation and some of the decisions of the courts have interpreted the prohibition in an unduly strict way.  The removal of this prohibition with effect from 1 October 2008 will give private companies increased flexibility to manage their own affairs.  It remains to be seen, however, how banks will react to the abolition of this prohibition and, in particular, to the disappearance of the whitewash procedure which has become a familiar feature of some financings.  It is very much to be hoped that banks will not continue to insist on a non-statutory whitewash procedure being followed notwithstanding the repeal of the statutory prohibition.

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Peter Graham

Consultant, Corporate Finance peter.graham@blplaw.com