Capital: The old Co-op conundrum re-emerges….

Andrew Bibby has published an interesting and thoughtful analysis in the Guardian of the issues currently faced by the Co-op Bank in the wider context of the problems faced by many co-ops in raising capital.

He outlines the interesting recommendations of Mark Hayes in a recent report for Co-operatives UK for the use of transferable shares in co-ops and the establishment of a secondary market in those shares. He also points to the difficulties faced in agricultural and other co-ops who have gone down the path of using equity capital while trying to maintain their co-operative identity.

Andrew points out that the Co-op Bank is a PLC owned by the Co-op group and comments that:

“Interestingly, the Co-op Group already has the legal powers to issue transferable shares to its members in the form of what its rule book calls Member Investor Shares. Were the Co-op Group to pursue this idea, it would create a major new financial instrument for cooperatives to develop further. Behind the scenes, recent lobbying by the co-operative banking sector has aimed to ensure that transferable shares of this kind are recognised under Basel III Tier 1 rules as core capital.”

This is a good point and the availability of transferable shares could be helpful. The problem will always be the existence of a market in shares of this kind and so the ease (or difficulty) with which they can be sold when people holding them want cash them in.

If the Basel III Tier 1 rules are tweaked to allow such shares to count, it seems unlikely that shares issued by the group would be directly relevant. They are not the bank’s capital.

However, the ability for the Group to raise more capital by a share issue might assist in plugging the hole in the bank, if the funds were then invested in the bank as further equity held by the Group in the bank. That would count because it was equity. When the shares were issued, it would have to be made very clear to those taking them that the purpose was to support the bank.

As I remarked in my long post on the bank last month:

“For co-operatives registered as industrial and provident societies capital raises difficult legal and regulatory issues.

Shares classified as withdrawable give the holder an exit possibility as the society can pay the money back and cancel the shares. This is contrary to the usual rule that corporate bodies (e.g. companies) are not permitted to buy back their own shares without special procedures and safeguards for creditors and remaining shareholders. However, apart from withdrawable shares held by other societies, only up to £20,000 worth of those shares can be held by any person (individual or company).

Non-withdrawable shares in societies are not subject to any limit on the value of a holding but they probably cannot be bought back by the society at all under the governing common law rule in Trevor v Whitworth. This is unfair to societies as companies, as long as they follow certain procedures and provide some safeguards, can buy back their own shares out of profits available for distribution or, in the case of private companies, even from capital not so available.

Primary legislation is needed to deal with this issue and to put societies in the same position as companies in that respect. If that were passed, it would significantly ease the position of all co-operative societies, including the Co-operative Group.”

There is no doubt that an expansion of the range of shares that societies can issue to  include redeemable shares that are not subject to the holding limit on withdrawable shares but that do offer an exit route subject to appropriate safeguards for creditors would be very helpful.

© Ian Snaith 2013 This work is licensed under the Creative Commons License
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4 Responses to Capital: The old Co-op conundrum re-emerges….

  1. Mark Hayes says:

    I should have thought that Trevor v Whitworth and the subsequent cases and statute law relating to the maintenance of capital does not apply to societies. Trevor v Whitworth related to a purchase of ordinary shares which was tantamount to an unauthorised reduction of capital under the Companies Acts. I cannot see that there is any similar provision against reduction of capital in the IP Acts nor how such a provision (or case law precedent) could be at all consistent with the issue of withdrawable share capital.

    Had Parliament intended that societies should maintain a minimum level of capital to protect creditors, the legislation would provide for that figure to be established and to prohibit withdrawals that would reduce capital below the minimum. Alternatively and more usefully, it might have imposed a minimum notice period of one year for the withdrawal of paid-up share capital, by analogy with the liability for one year of past members (under section 57, IPSA 1965) to creditors at the time of leaving membership, to the extent of their unpaid capital. However, neither requirement was imposed on societies and I can think of several good reasons why this makes historical sense.

    For present purposes, the market value of transferable shares is significantly reduced without the prospect of an exit (short of solvent liquidation or conversion into a company), since it can be based only on the running income yield without allowance for the return of capital. Furthermore, without redemption, it becomes impossible for societies to replace expensive capital issued at an early stage, once the society’s business becomes established and is perceived as lower risk, or if market interest rates fall. I assume the removal of the individual shareholding limit was intended to be more helpful than that and not to undermine the democratic nature of societies by tending to force conversion. If you are correct, the 2011 deregulation order is flawed in principle. On the other hand, perhaps HM Treasury and Parliament know what they are doing?

    • isn says:

      Thanks for the comment, Mark. In policy terms, I agree – although surely shares in companies are valued on the basis of a secondary market and not the possibility of buy back by the company?

      However as a matter of law, I think that Trevor v Whitworth would be applied by the courts to societies because it protects creditors.

      Parliament has explicitly provided that some society shares can be withdrawable and that trumps the Common law rule. However, in other cases, i.e. non-withdrawable shares, the Trevor v Whitworth principle is likely to apply because:

      1. It prevents shareholder/owners who hold risk capital from jumping the queue ahead of creditors. That is the basis for the order of distribution on insolvency. Creditors cannot sue members personally and have to rely on information about the share capital and reserves. In the case of a society they know that withdrawable share capital may be withdrawn. They do not know that about other forms of share capital.
      2. A society, as a corporate body providing limited liability for its owner/members, is indistinguishable in this respect from a company.
      3.The case was decided by the House of Lords – the highest Court in the system. That gives it very high legal authority, assuming that it applies.
      4. In the absence of explicit statutory reversal of the principle, I think one has to look to case law and this is the case law that seems most relevant.
      5. The LRO (removing the holding limit for non-withdrawable shares) was secondary legislation. It was not debated by Parliament as primary legislation would be. That is a slim foundation for an intention to undermine such a well established and fundamental principle of creditor protection for corporate bodies whose members enjoy limited liability.
      6. Companies are allowed to buy back their shares or issue redeemable shares only if they follow procedures for the protection of creditors – see Companies Act 2006 Part 18. To allow it without that creditor protection for societies’ non-withdrawable shares would be a big step.
      7. Maybe there is a historical argument to be made along the lines you suggest but my view is that it would be hard to succeed with it against such a fundamental principle of creditor protection.
      8. I agree with what you say about the historical context of Trevor v Whitworth. However, companies are now no longer required to state their authorised share capital in their memorandum (or articles) as the Companies Act 2006 abolished that requirement. However, this capital maintenance principle remains in place for them (ss 658 & 659 CA 2006) subject to Part 18 and reductions of capital with court consent – Chapter 10 of Part 17 of the 2006 Act.

      Until a case arises to deal with this, it remains a debatable point. However, for the above reasons I don’t think it would be safe to assume that the principle is inapplicable to societies – inconvenient as that is. The safe solution is legislation to deal with the likelihood that Trevor v Whitworth applies to societies and to allow at least redeemable shares not labelled as withdrawable or, preferably, to apply the Part 18 CA 2006 rules to them.

  2. Mark Hayes says:

    On policy, you are right, of course, that holders of company shares usually rely upon the secondary market rather than the prospect of a purchase by the company. However my point runs deeper, to what determines the market price of transferable shares.

    I make a distinction between exit and liquidity. Secondary markets provide liquidity and therefore an exit for the individual shareholder. However an individual’s sale price depends on the next individual’s assessment of the prospects for onward sale, which depends on the next individual’s in turn, and so on. I am concerned with what lies at the end of the logical chain and underpins the market valuation.

    The critical difference between a company and a society is that the former is quite likely, at some point, to be sold as a whole and this may indeed be the active goal of the controlling shareholders. A private company can therefore offer the prospect of an exit at a price which reflects the overall market value of its business, even though its shares are not listed on a secondary market and therefore not liquid. By contrast the sale of a society (or its business) is never a primary goal and usually an admission of defeat. The historical importance of withdrawable share capital is that it provides liquidity for shareholders without the need for an ultimate sale.

    Transferable shares in a society can therefore be valued only on the basis of their dividend yield (in company parlance) if there is no real prospect of redemption by the society together with the redemption premium that I would regard as necessary to attract capital of a ‘permanent’ nature. It is true that profitable redemption could take place through the sale of the business followed by solvent liquidation but this is not something that user members are likely to want. Therefore the market value of transferable shares is significantly reduced if you are correct that societies do not have power to redeem non-withdrawable shares.

  3. Mark Hayes says:

    I now see that section 57 IPSA 1965 can make members liable to repay withdrawals in the event of insolvency within one year, although I suspect this is not widely understood. The legislation’s approach to protecting the interests of creditors seems different to that of company law. Section 57 (d) does not limit either repayment (i.e. a reduction in the amount paid up) or contributory liability solely to withdrawable shares. Paragraph 57 (e) merely defines the date at which the clock starts ticking when the repayment is at the member’s option and sets this date earlier than the actual date of repayment, i.e. to the date when the member decides to withdraw financial support. If a share were redeemed at the society’s option, the effective date would be the actual date. However I do not think section 57 recognises the purchase, as opposed to redemption, of shares.

    Extension to societies of the provisions of the Companies Acts that permit the reduction, redemption or purchase by the company of non-withdrawable share capital would indeed clarify and codify the matter, but I suggest it is unnecessary and inappropriate. Society law is curiously modern in its approach and in line with the obligations of directors under the Insolvency Act 1986. There is considerable merit in aligning societies, not with companies, but with modern limited liability partnerships, to which in historical terms societies are a precursor.

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