The board's power to allot shares is subject to various constraints.
This is the fourth in a series of articles in which we explore the role of a director from various angles, some of them slightly unconventional. Each article identifies a fact of which directors need to be aware - whether concerning their duties, their relationship with other key players or their responsibilities under the Companies Act 2006 - and uses it as a starting-point to illuminate a particular aspect of their role.
This article discusses the directors' role in relation to allotting shares.
The fact that a company can raise funds not just through borrowing, but also through issuing new shares is one of the key features of the corporate structure. Given that directors will normally be in the best position to assess their company's financial needs, it might be thought that the power to decide when, and to whom, to allot shares is entirely in their hands. In fact, this is not the case. In the interests of protecting shareholders, the company law regime contains various measures designed to restrict the board's freedom in this area.
The board may need to obtain shareholder authorisation before it allots any new shares.
The general rule under the Companies Act 2006 is that directors may not allot shares unless the shareholders have authorised them to do so, either by means of an ordinary resolution or by means of a provision in the articles of association (section 551). The authorisation must be for a period not exceeding five years (although it may be renewed), and must specify an upper limit on the amount of shares which may be allotted under it.
A slightly different approach is adopted in relation to private companies with only one class of shares, in that the directors of such companies can allot new shares of the same class without shareholder authorisation provided that the articles do not say otherwise (section 550). Clearly, the default position here is in favour of greater freedom for the board, but crucially the shareholders can restrict that freedom at any time by amending the articles.
Existing shareholders enjoy a right of first refusal over any newly-allotted shares.
The statutory pre-emption right, as it is known, is designed to protect shareholders against the risk that their holding in the company might be diluted as a result of an issue of new shares. Take the case of a company with two shareholders, each of whom owns 50 shares and therefore has a 50% stake in the company. If the company were to allot 100 new shares to two new shareholders, the original shareholders' stake would be reduced to 25% each (ie 50 shares out of a new total of 200 shares), and their power to control the company's affairs would be diminished to the extent that they could not pass an ordinary resolution without the support of at least one of the new shareholders.
Recognising that investors will be disinclined to put their money into companies if the risk that their stake will be diluted is too high, the Companies Act 2006 requires new shares to be offered first to existing shareholders in proportion to their holding in the company (section 561).
This statutory right is essentially a default provision. On the one hand, the shareholders can opt to disapply or exclude it (sections 567-571). On the other hand, it can be enhanced by provisions in the articles. For example, whereas the statutory right does not extend to allotments where the proposed consideration is not entirely in the form of cash, the shareholders may wish to specify that they have a right of pre-emption regardless of the nature of the consideration.
Directors who are planning to allot new shares must, therefore, be alive to the possibility that their freedom to do so may be restricted not only by the statutory right, but also by any enhanced right which the shareholders have given themselves in the articles.
The statutory directors' duties apply to decisions to allot new shares.
When a director votes on a proposal to allot new shares, he is subject to his statutory duties in just the same way as he is when he takes any other decision. He must, for example, be seeking to promote the success of the company in accordance with section 172, and in doing so must have regard to the mandatory factors specified in that section. Consider the case of a company which wishes to raise funds through an issue of new shares, and has received expressions of interest from two individuals, one a reputable local businessman with whom the directors have no personal relationship, the other a friend of the directors who has a past conviction for fraud and whose association with the company might alarm some of its suppliers. In deciding to whom they should allot the shares, the directors must put their personal feelings to one side and opt for the course which they genuinely feel will best serve the company's interests.
The duty under section 171(b) to exercise powers only for the purposes for which they are conferred is also particularly relevant in this context. There is no exhaustive statement in the case law of the purposes for which the power to allot shares is conferred, but certainly the main purpose is to enable the company to raise money. It is also clear that directors who use the power in order to adjust the shareholder base to their liking will be in breach of the duty (Howard Smith Ltd v Ampol Petroleum Ltd (1974)). Thus, a board which is at odds with the majority shareholder over, say, a proposed acquisition will be misusing the power if it allots shares to a friendly third party in order to reduce the majority shareholder's stake and, therefore, its ability to influence the company's affairs.
In most cases, the directors will be of one mind with the shareholders in relation to a proposed allotment of shares, in which case complying with the relevant statutory provisions will be little more than a compliance exercise. Directors need to be aware, though, that where there is any disagreement, the balance of power in this area, as in so many others, is weighted in favour of the shareholders.