What Exactly is Legal Capital?
What is legal capital? The legal capital of a corporation refers to the portion of a company’s equity that cannot be returned to shareholders as a distribution, mirroring the original value of their investment. In a limited liability company ("LLC"), however, legal capital may refer to the total member contributions that are recorded in the LLC’s literature as a part of the capital accounts of each individual member.
As a legal matter, the concept of maintaining legal capital in a company’s structure arose with the purpose of guaranteeing that sufficient debt is available to pay company expenses and obligations after a liquidation event. It is one way a creditor can ensure its security. The legal capital standard is carried out through the use of par value per share (typically a small amount, such as one cent – but there is no regulatory minimum of par value), which represents the legal policy determining the amount of capital that will be maintained in the company even after returns to shareholders. The par value of a share is required to be the same for those shares of a particular class, though the par value may differ among company stock classes. Other than relatively few exceptions , the par value of a share cannot be reduced once it is paid in, even though shareholders may receive full refunds of capital after liquidation – the legal capital requirement still has to be satisfied and this is what the par value is intended to protect.
The balance on the balance sheet that is labeled as "legal capital" will remain the same between liquidation events even though money may be distributed to limited partners when a liquidation event occurs. Legal capital may also refer to the capital of a company that is attributable to the shares that have been issued and paid for by shareholders, after deducting the company’s stated capital (which is the sum of all amounts paid to the company by shareholders). It is important to note that legal capital is not the same thing as "distributable reserves," which is an accounting concept that refers to the capital that can be returned to shareholders as a profit distribution. Amounts that are designated in a capital account, capital surplus or share premium account as distributable reserves cannot be returned to shareholders unless they are actually being returned in the form of a distribution that complies with statutory requirements.
The Importance of Legal Capital
The concept of legal capital plays an important role in several aspects of corporate and securities regulation. From the SEC’s perspective, the concept of legal capital provides a mechanism for protecting the interests of creditors, and helps with the prevention of fraud or mismanagement by corporate management. Legal capital is also significant in its function as a means of preventing unfair discrimination among the stockholders of a corporation.
Legal capital restricts corporations from paying dividends to their shareholders until the capital stock of a corporation has been purchased and paid for. As a general rule, these restrictions are defined in the articles of incorporation and restate of corporate laws. Thus, payment of dividends is strictly tied to the amount paid into the capital stock of a corporation by its shareholders.
Specifically, the doctrine of legal capital assumes that a jury will remove or dissolve the surplus assets of a corporation through the process of determining the amount of legal capital. The surplus funds or assets are part of the fund against which judgment can be satisfied. When it comes to satisfying the debts or obligations of a corporation, the only thing that can be recovered from the surplus assets is the amount paid in exchange for the shares of stock. This ensures that creditors are protected against fraud or mismanagement by corporate management. Legal capital is particularly significant when a corporation is faced with a wind-up or liquidation scenario.
Legal capital can prevent the dilution of shareholders’ equity. When stock is purchased, it is important to make sure that the stock is not subsequently reduced or diluted. In this way, legal capital protects against dilution of the equity enjoyed by stockholders of a corporation.
The Parts that Make Up Legal Capital
One fundamental element which characterizes corporate capital can be identified in the concept of "legal capital". Legal capital has been defined in many ways, including as "the amount below which corporate assets may not be unlawfully withdrawn from the company without a supervening statutory violation."
The most important concept here is the concept of "par value", which is the value thus fixed. In contrast, any price above par value at which shares of stock are issued is a share premium. When a corporation issues shares, its officers and directors must ensure that the total amount of share capital it receives from the sale of shares is no less than the amount stipulated in the authorized shares. If shares have been issued with par value, the company must receive the amount of consideration at least equal to the par value of the shares.
For example, a company has an authorized capital of $10,000 divided into 1,000 shares with par value of $10 each. It charges US$12 for its shares, up to $1.8 million. In such a case, the company would be able to issue a total of 100,000 shares at a price of $12 each. It will thus have $1.2 million share premium (US $12 x 100,000 – US $10 x 100,000) and a capital of $1 million (US $10 x 100,000) in addition to the US$1.2 million share premium. If the shareholders approve the issuance of additional shares for cash, the authorized capital will increase from $10,000 to $1.2 billion ($1 million + $1.2 million).
Another important concept to know is the concept of "paid in capital". Paid-in capital refers to the total amount of capital that has been paid in by shareholders to the corporation in exchange for stock. It is a combination of both "contributed capital" and "donated capital". Contributed capital refers to the sum of par value of all the issued shares; donated capital refers to the sum of par value of all donated shares.
Legal Capital: Shareholder Equity and the Complex Relationship
Legal capital has a significant impact on shareholder equity. Shareholder equity is the net assets remaining after a company’s liabilities are deducted from its assets. Since legal capital restrictions are intended to protect creditors, such legal capital maintenance requirements generally reduce the assets that may be available for distribution to shareholders until the legal capital hurdle is met. In many jurisdictions, a company’s capital is considered impaired when any of its assets are distributed to its shareholders. As the capital impairment rules generally prohibit capital reductions, regulatory actions are sometimes necessary to allow distributions of assets to shareholders. Companies often seek such relief even when any actual impairment of corporate capital is de minimis. As a result, if a company were to vest discretion to the directors to fulfill the capital impairment rules through share buy-backs or other reduction mechanisms, directors may be subject to liability to the company and its creditors if they make a decision to redeem shares that would otherwise be impermissible.
Upon dissolution or winding-up of a company, any excess assets remaining after payment of all liabilities are payable to the company’s shareholders or members, if any, according to their respective rights and interests in the company, but subject to the company’s articles. If an insolvency event occurs, however, special rules apply. In order for the Articles of Association or other governing documents to have priority over the capital impairment rules, a directive must be set out in the company’s Articles of Association giving the Board discretion to establish the priority of distributions. To be effective, such express inclusion in the Articles of Association, together with an independent valuation, would generally need to be approved by an ordinary majority of creditors.
Are Capital Requirements Under Legal Capital law Uniform Across All U.S. Jurisdictions?
The concept of legal capital is regulated differently across jurisdictions. Significant differences in jurisdictions’ legal capital requirements concern the composition of legal capital, including: Such discrepancies lead to divergence in how corporate transactions are consummated across jurisdictions. Companies can avoid the risks and liabilities associated with the issuance of benefits or reductions of capital that would otherwise be subject to legal capital requirements. Also, while it is relatively easy in the United States to enter into corporate transactions such as capital reductions, a number of countries impose complex, detailed rules and procedures for any transaction that will reduce statutory paid-in capital.
In the United States, some states (such as Delaware, California, Maryland, Pennsylvania, Texas, Florida) have eliminated the concept and regulations surrounding "legal capital." Other states (such as Delaware, Texas, and Illinois) have retained the concept, but made it applicable only to certain types of entities. Most US jurisdictions have made modifications to the traditional legal capital requirements.
This modification of the legal-capital framework has had a significant effect on corporate finance for public offering transactions and private equity funds. In the case of venture capital and private equity funds, the funds, despite their legal form, are not subject to the legal capital requirements. In the case of public offerings of equity securities, companies do not have to be concerned with "legal capital" restrictions in deciding prices for public offerings . For example, companies can, under the laws of many jurisdictions, issue shares for less than par value, whereas "capital" in the traditional legal capital sense was intended to reflect something real, so shares could not be issued below par to protect creditors from being underpaid.
Similar to the United States, a number of EU member states have taken steps to eliminate the concept of legal capital, while at the same time retaining the concept and regulations surrounding "reserve capital." The difference between the US and the EU is that, in the EU, all countries have retained the requirement of other forms of capital (such as reserve capital), even if they do not have an applicable legal capital concept.
Instruments with a fixed maturity (also known as "debt securities") may include bonds and notes of any type, and a wide variety of fixed and floating rate debt instruments. Since these instruments are specified and determined in the indenture governing each particular instrument, and since the indenture is an individual contract, it will be governed by US contract law and not much else. Some jurisdictions that otherwise may not qualify these instruments as "debt" instruments do treat them as such for statutory readjustment purposes.
Legal capital concepts, derives from the German Commercial Code, sections 30 et seq., also known as Handelsgesetzbuch (the statutory capital of German corporations). Under this law, each German corporation must determine its statutory capital. These German statutory capital requirements are similar to those in Delaware corporate law, except that German statutory capital requirements are more conservative, and also apply to capital companies (i.e., limited liability companies).
How Legal Capital Can Impact Your Business Decisions
The implications of legal capital for business decisions are most readily apparent in the case of raising funds, by reference to which the various legal capital maintenance and distribution rules are best defined. In short, raising funds by way of equity (i.e., through the issuance of shares) will tend to offer more latitude in terms of capital maintenance and distribution restrictions than raising funds by way of debt. That said, raising funds by reference to other forms of financing may impose additional requirements, including, in particular, with respect of security and contractual restrictions on distributions to shareholders.
The implications of legal capital also arise in merger and acquisition contexts, including with respect of asset purchase agreements (the contents of which may be substantially influenced by legal capital considerations, in particular by way of shareholder approval requirements as discussed above).
Special consideration may arise in the context of convertibility and rights issues, particularly where the securities involved are cumulative in any respect (i.e., such as preferred classes of shares and whether to suspend further interest accrual). The balancing act between capital maintenance and distribution restrictions is particularly relevant in this regard.
Other special case issues may also arise, including those related to the set-off of indebtedness, as well as restrictions on the giving up or abandoning corporate property or assets.
In all circumstances, organizations must bear in mind that the consequences of disregarding legal capital requirements may be significant, including with respect to possible personal liability for directors.
Evolving Developments on Legal Capital
Over time, legal capital has become less important to the various entities subject to it, and so states have moved away from their laws establishing legal capital. Not surprisingly, this development matches advances in technology that make it easier for companies to raise funds from large numbers of investors at smaller amounts per investor while at the same time making it more difficult for any one investor to effectively monitor that investment on an ongoing basis. As a result, while the Uniform Business Organizations Code ("UBOC") continues to address legal capital in section 201.02 of the model limited liability company ("LLC") act, UBOC section 503 articulating the law of limited partnerships , and UBOC section 303 concerning corporations, have moved away from legal capital: both allow entities to issue interests without regard to legal capital. Section 103(a) of the former model business corporation act also provided for unlimited issuance of shares without regard to legal capital, as has in recent years been the case with state acts adopting the model language. The former model act contained no definition of legal capital, but did define "reducing capital" as "the act of paying any amount of money to shareholders out of capital." As noted previously, although the UPC does not use the term "legal capital," its strict financial statements rules must be complied with if an unlawful dividend is to be avoided.