Share buy backs – what could go wrong?

What is a share buy back?

A share buy back is the procedure by which a company acquires its own shares from its shareholders. Share buy backs are often used by companies to return surplus cash to shareholders or to provide an exit route for shareholders.

What could go wrong?

To be valid, a share buy back must comply with Part 18 of the Companies Act 2006 (the Act). All too often the requirements of the Act are not complied with when conducting a buy back. The most frequently overlooked requirements are:

1. The need for distributable profits – One of the most common ways of funding a buy back is from a company's distributable profits. The absence of distributable profits, where this is the method of financing relied upon, will make a buy back void. Prior to effecting a buy back in this way, a company should engage with its accountants to ensure that there are sufficient distributable profits available to effect the buy back.
   
   
2. Making payment for the buy back in full at completion – The Act provides that payment for a buy back must be made in full at completion. This means that deferred consideration for a buy back is not permitted (and advance payments are also unlikely to be acceptable). This error is very commonly seen but is fatal to the lawfulness of the buy back.
   
   If a company does not have the funds available at completion to fund the buy back in full, there are a number of alternative options available, including:
   
   - Undertaking the buy back in tranches – In this case, there must be sufficient distributable profits available at each point a purchase of shares is made. A buy back in tranches may not be desirable if the company's intention is for a shareholder to be removed from the company immediately; and
   
   - Borrowing from a bank or third party to fund the buy back.
   
   
3. Shareholder approval of the buy back – A buy back requires the approval of shareholders by way of an ordinary resolution (i.e. a simple majority) of all shareholders other than the shareholder whose shares are being bought back. Even if the buy back is agreed by all concerned, it is essential that such a shareholder resolution is passed to approve the buy back.
   
   
4. Restrictions in the company's articles of association – Although it is not necessary for a company's articles of association to permit a buy back, before a buy back is contemplated it is essential to check that the company's articles of association do not prohibit a buy back.

If a buy back does not satisfy the requirements of the Act – whether as set out above or otherwise – the shares which have been supposedly bought back are, in fact, likely to be still in issue and held by the original shareholder.

What are the consequences?

This can have serious repercussions for a company. For example:

• All shareholder resolutions passed by the company since the purported buy back will be invalid because they will not have been voted on by the shareholder whose shares were purportedly bought back.
• Any share issues since the purported buy back will not have been offered pre-emptively to the shareholder whose shares were purportedly bought back.
• Any prospective buyer of, or investor in, the company will almost certainly want the company to take costly and time consuming measures to rectify the defect before they will be willing to proceed with a purchase or investment. In the worst case scenario, it might put a prospective buyer or investor off the purchase or investment entirely.

What is more, if a buy back is conducted otherwise than in compliance with the requirements of the Act, the company and its directors will be guilty of an offence which is punishable by up to two years in prison and/or an unlimited fine.

What should I do?

If you are thinking of undertaking a buy back of shares in your company, please get in touch with a member of our team of specialist Corporate lawyers and we can help to make sure that the buy back is effected lawfully and validly.

Similarly, if you think your company might have been involved in a defective buy back, we can advise you on the steps we recommend to rectify the error and to ensure that the intention of all parties is put into effect.

Why now?

The sooner a defective buy back is resolved the better, particularly if it is intended that the company will be sold in the future or that external investment will be sought. What's more the longer a defective buy back is left unaddressed the more difficult it is likely to be to rectify. A defective buy back is just the kind of thing that might make a prospective buyer or investor think twice about their decision. Taking the right steps promptly can save time and money in the long term and avoid a future exit or investment opportunity being put at risk.

These notes have been prepared for the purpose of an article only. They should not be regarded as a substitute for taking legal advice.