Argument (#01-02 January-February 2013)

English Company Law as an Example to Follow

Volodymyr O. Yakubovskyy

The private or closed corporate form with limited liability was specifically chosen as an object of this article as the rules on limited liability companies demand urgent reform in Ukraine. The author further believes that particular attention should be drawn to problematic legal capital rules for limited liability companies in Ukraine.

At the same time, English company law currently has one of the most efficient legal capital mechanisms for private companies in Europe that ensures adequate protection of creditors’ interests. Thus, if Ukraine wants to develop an efficient respective regulation in its legal system taking into consideration the English experience, it is important to comprehend those legal capital rules of company law in the UK in order to follow them.

What is the background of Ukrainian law on limited liability companies?

Ukraine is considered to be a civil law country with an emerging economy. Ukrainian company law functions in an environment which has all typical negative features of an emerging economy, such as dominance of self-dealing majority shareholders and self-interested managers, severe asymmetry of information, corrupted and malfunctioning courts, weak and incompetent regulators, poorly developed capital markets and self-regulatory institutions.

In circumstances of such underdeveloped market and legal infrastructure, company law is particularly important and has its specific set of goals to be achieved as a “protective mechanism” for investors against opportunistic behaviour of the self-dealing managers and majority shareholders.

For the years of state independence, Ukrainian company law has failed to serve its political goal to “foster public confidence in a market economy and in private ownership”. According to a survey conducted annually by the World Bank, Ukraine’s regulatory environment, in which company law plays an important role, is steadily ranked at the bottom of the table as to the ease of doing business in comparison not only to developed economies, but also to other post-Soviet economies.

The primary function of company law — “value maximizing” and “encouragement for entrepreneurship and enterprise” — is distorted in Ukraine, as modern Ukrainian company law fails to adequately protect investors. Ukrainian company legislation is commonly referred to as a “conglomerate” of controversial, inefficient, burdensome and sometimes artificial and outdated legal rules that one can find in several parallel and usually inconsistent legal acts.

In order to boost the confidence of investors and enhance the attractiveness of Ukrainian business, company law in Ukraine requires fundamental systematic reform. This need is most urgent with regard to the rules on limited companies that are commonly considered to be the most attractive business vehicles in developed jurisdictions, being optimal organizational forms to encourage risk-taking and thus innovation due to its specific characteristics — limited liability, separate personality, and transferability of shares.

The author believes that one of the most controversial and undeveloped legal concepts of existing Ukrainian law are legal capital rules for limited liability companies. On top of this, those rules are characterised by an absence of adequate supervision from a regulator, lack of public policy behind them and unified practice, poor understanding and nominal compliance by market participants, including creditors, shareholders and managers. Neither has modern discussion over legal capital regulation for limited liability companies been sufficiently reflected in the recent works of Ukrainian scholars.

What is the background and current status of English company law?

Unlike Ukraine, the UK has a developed sound market economy with strong company law. As one of the leading developed economies, English company law is characterized as “enabling” law since it functions in an environment with profit-oriented professional managers, competitive product markets, efficient capital markets, sophisticated courts, active and competent regulators and self-regulatory organizations.

Investors and creditors have sufficient and reliable information on the companies from sophisticated professional accountants, elaborate financial disclosure and active financial press.

The directors are under the close eye of the courts, having various statute and common law remedies and sanctions to ensure adequate ex post control against their opportunistic behaviour.

The United Kingdom has significant experience in regulating the capital of companies and protecting the interests of creditors in this regard.

The UK Parliament recently revised and improved its rules on limited companies. The possibilities to reform English company law were significantly restricted by European Union law with regard to public limited companies. With regard to private companies, the UK, as all other member-states of the EU, had more discretion to regulate a private company limited by shares, which the author believes is the most similar form to the limited liability company in Ukraine. Taking into account lengthy evolution, traditions of that legal system, and recent developments in most developed economies, Parliament enacted the Companies Act 2006. The reformed Act was intended mainly to codify and simplify the rules for limited companies in order to reflect the modern trends and needs of business.

Comparing legal capital rules for LLCs in the UK and Ukraine

The basic idea of the legal capital concept is to ensure protection for both creditors and investors against opportunistic behaviour of managers and majority shareholders. The main ground for the legal capital regime is that where shareholders of a company have limited liability and such a company operates as a separate person, creditors who trade with this company will have to count only on the assets of the company to satisfy their claims. Thus, to meet the claims of voluntary and involuntary creditors, the law provides for a protection mechanism that ensures that a limited liability company operates only with an appropriate level of assets through the rules on the raising and maintenance of capital. The legal capital is defined as “a broad concept that embraces the rules relating to the raising of capital through share issuance, the maintenance of share capital, and the returning of value to shareholders in circumstances that do not infringe the maintenance of capital requirements”. This concept is also generally referred to as the doctrine of “capital maintenance”.

In the UK, the doctrine of legal capital was developed together with the concept of limited liability. Since the end of the XIX century, English courts have gradually developed a system of principles and rules directed on the formation and maintenance of share capital of a company. Then those rules were codified and modified in company law acts. Now these rules are, in essence, rather technical and complex as they establish a number of prohibitions and exceptions. It has been developed and extensively criticised by numerous scholars, and the general trend is towards moving away from the legal capital doctrine to an alternative and more efficient mechanism of creditor protection already implemented in a number of developed countries. Not bound by the requirements of EU law, the rules on formation and maintenance of capital in the UK for private companies are considered to be heading towards those alternative mechanisms. The company law of England and Wales is now considered to have clear and simple share capital rules that put little regulatory burden on private companies and encourage the entrepreneurship.

It is worth mentioning that in the mentioned World Bank report on ease of doing business, the United Kingdom is consistently ranked among the top 10 world nations and number 1 in Europe. Within the EU, the UK is, for this reason, commonly chosen as a jurisdiction for incorporation of closely held businesses among other member-states and currently leads the regulatory competition in this regard.

At the same time, while Ukraine does also recognize the concept of “legal capital”, when comparing Ukrainian law regulation of legal capital with the one in the UK, one will find that Ukrainian rules taken separately are more strict and burdensome for limited liability companies than those developed in the UK. Ukraine has failed to develop the concept as a system of mechanisms in order it to operate in a proper manner. So one can see that some available measures are rather strict while, due to the lack of some other important elements, the system does work — it fails to adequately protect the interests of creditors.

The UK legal rules on share capital formation of private companies are considered to be clear and simple and so encourage entrepreneurs within the EU to incorporate in the UK. The UK keeps its traditional approach which does not require a private company to have any minimum share capital, which forces other countries to follow under pressure of regulatory competition. Though some of the concepts related to capital formation, like nominal value of shares, are considered to be of doubtful utility, those rules seem still to provide for adequate and efficient protection of creditors’ interests. So as to improve its reportedly unattractive investment environment, Ukraine has recently significantly abandoned the minimum capital requirement. Ukrainian rules on share capital formation prove to be not only ineffective from the perspective of creditor protection, but also discouraging and creating distorted incentives in capital structuring. In particular, it is proposed to cancel the requirement to confer the share in monetary value and allow shares to be conferred in percentage or as a fraction. The options of consideration for capital contribution should be expressly extended.

The rules on capital maintenance restricting the return of capital of a company, in particular through distributions, share buy-backs or reduction of capital, to its members at the expense of creditors, have a long history in English law. Through more than a century, English law has developed detailed and complex rules governing all possible ways whereby assets may be returned to shareholders, which provide effective protection for creditors’ interests. Even though restricted by European Union law to a certain extent, some rules have recently been supported with more relaxed procedures. Those procedures, which are based on a solvency statement and disclosure requirements, provide for time and cost efficient mechanisms that, nevertheless, ensure adequate protection for creditor via stricter liability for managers and members in default. Ukrainian legislation currently in force is very limited and contains gaps and loopholes with regard to restrictions on return of capital to members by means of distributions and share buy-backs for limited liability companies, while offering inefficient and outdated regulation through the tying of a company’s net assets to its legal capital at the end of a financial year instead.

It does not provide a comprehensible procedure for reduction of capital. Due to such lack of legal certainty, the management and majority members of limited liability companies commonly abuse these rules in their own interest.

There are proposals to consider radical reform the capital maintenance rules in Ukraine by abandoning the existing regulation and employing modern and more efficient concepts, which have been already partially incorporated into English law.

It is proposed to incorporate into Ukrainian law a unified mechanism based on a solvency test and balance sheet test, disclosure requirements, directors’ liability, civil remedies to refund unlawful return of capital so as to regulate all transactions of distributions, share buy-backs and reduction of capital.

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