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Introduction. The Companies Act 1993 applies awkwardly to typical issues by the one- and two-person companies which comprise around 80% of new registrations. This article identifies some obvious problems and associated liability risks. For solutions and strategies, many of which are not intuitively obvious and often involve a close reading of the statute, the interested reader is referred to the extended discussion found on the webpage www.vuw.ac.nz/~mckenzie.

The contractual framework and its regulation. A share issue generally occurs within a contractual framework, which is often informal or implied in the case of a one- or two-person company. The agreement provides, at a minimum, that the company undertakes to issue a specific number of shares for a set consideration. Most of the rules for share issues can be viewed as regulating various aspects of this contractual framework. For instance,

These rules, which have no counterpart in relation to other bilateral contracts, were designed to deal with perceived abuses of the corporate form. However, their operation is uncertain and/or unsatisfactory as applied to common variations in the incorporation of one- and two-person companies. These include the usual choices in relation to original or shelf registration, the adoption of a company constitution, nominal or substantial equity capitalisation, and payment or deferral of the subscription price.

The application of s 47(1) to the initial issue. Consider first the simplest configuration-the one person company under an original registration, without a constitution and with nominal paid up capital. The shares will be issued to the single member under s 41(a) pursuant to an informal or implied subscription agreement in the absence of a constitution. Section 40 makes the agreement illegal unless the board complies with s 47. Sections 47(1) and (2), the limb relevant for initial issues, require that the principal, in her capacity as the sole director and board, make specific determinations, resolutions and certifications respecting the consideration and the shares. Section 47(5) requires that the certificate be delivered to the Registrar. However, s 47(1) expressly applies only to issues under ss 42 and 44. The uncertainty is whether, in the case of an initial issue under s 41(a), s 40(b) requires compliance with s 47(1). Whilst the decisions required by s 47(1) are trivial under the circumstances, the potential consequences of noncompliance are not. Noncompliance is an offence attracting a penalty up to $15,000. Noncompliance also makes the issue illegal and consequently undermines subsequent actions, e.g., voting and distributions, based on the shares.

Shelf registration and a long form constitution as complicating factors. The matter is further complicated by the use of a shelf registration or a long form constitution. Where the client acquires a shelf-registered company, the initial issue under s 41(a) will have already taken place. Accordingly, any new equity capital must be injected as consideration for an issue under s 42 or s 107(2). An issue under s 42 is expressly subject to the protocols of s 47(1). Whilst s 107 was designed to provide relief against such formalities, its application under the circumstances is not free of doubt. On its terms, s 107(2) excuses compliance with ss 42 and 44 but not s 47. The problem is exacerbated by the provisions of the standard long form constitutions commonly used in the incorporation of closely held companies. These constitutions almost invariably quote or restate s 47 in its entirety. However, not infrequently, presumably to enhance the readability of the document, the drafter has omitted the statutory cross-references found in s 47(1). So, even if these references are construed to extend the scope of s 107(2) relief to s 47(1), the principal must still comply with the counterpart provisions of the company constitution.

Issued but unpaid shares under s 47. The operation of s 47(1) is particularly problematic where, as in the case of a substantial equity capitalisation, payment of the consideration for the shares is deferred. Deferred payment may make the issue one other than for cash, i.e., one for a contract claim against the subscriber. If so, the board must resolve that the reasonable present value of the unpaid amount is not less than that credited for the shares. However, this resolution is possible only if the unpaid share price carries interest which realistically reflects the risk of nonpayment. As the principal's financial fortune is usually linked to that of the company through guarantees and a remuneration scheme, the risk is an appreciable one, consistent with an interest rate considerably above the bank rate. Further, the present value calculation will require the assistance of an advisor, which delays and raises the cost of the issue.

Issued but unpaid shares as financial assistance. Deferral of the subscription price may also constitute financial assistance in connection with the purchase of a share to be issued by the company. Section 62 of the 1955 Act also expressly applied to financial assistance in connection with share subscriptions. For financial assistance under any of the three modes in s 76, the board must resolve that the transaction is in the best interests of the company and on terms which are fair and reasonable to the company. Such resolutions are problematic in view of the cash flow problems which plague small firms from the outset and even more troublesome where, as often happens, the unpaid subscription price does not carry interest. Implementation of the assistance under s 107(1)(e) excuses compliance with the fairness and best interests requirements in s 76 but not the comparable requirement in s 131. Further, whether implemented under s 76 or s 107(1)(e), the assistance must satisfy the solvency test in s 52 or s 108 respectively. This generally requires additional planning where the issue is the first transaction undertaken by the company.

Shares for non-cash assets. A valuation will be required by s 47 where, as commonly occurs, shares are issued for services, the assets of a going business or a specific asset needed by the company. The valuation forms the basis for the determinations, resolutions and certifications anticipated by that section. Even if compliance is excused by recourse to s 107(2), the value of the assets is a term of any express or implied subscription agreement. As illustrated by the case law, the valuation of any non-cash asset results in a range of figures, the highest being several multiples of the lowest. Selection of a figure within this range has important legal consequences. First, in a multi-person company, an overstated value will dilute the control and return rights of the cash subscribers. In this connection, the failure to comply with s 47 constitutes prejudicial conduct under s 175(1)(b) and the signing of a certificate without reasonable grounds comprises prejudicial conduct under s 175(2). Secondly, an overstated figure can lead to a breach of the solvency test. In the event of insolvency, the liquidator or receiver will argue that one or more distributions contravened the balance sheet limb as applied using the true as opposed to the (over)stated asset valuation. Contravention of the solvency test exposes the principals to both criminal and civil liability which continues, in theory, for the life of the company. Thirdly, overvaluation can result in eventual liability under ss 297 and 298 which entitle the liquidator to recover from persons who transfer assets to the company at overvalue.

Shares for services. The issue of shares for services requires particularly careful planning in view of ss 46 and 47. The past consideration constraint in s 46 poses an obvious problem where the shares are issued for services rendered in connection with the incorporation of a new or existing venture. The rendition of the services antedates not only the date of issue but also often the date of any subscription agreement. Services also constitute non-cash consideration for purposes of s 47 and, where shares are issued for post-incorporation services, confront the board with the difficult task of assigning a value to an unexpired service contract. Unlike tangible goods, an unexpired service contract generally has no value in liquidation. The liquidator or receiver will argue that the service contract was booked at an inflated value which enabled the company to make distributions in contravention of the solvency test. As true in relation to other non-cash consideration, the use of s 41(a) or s 107(2), even if applicable, provides only partial relief.

Initial issue of shares as a major transaction. The initial issue of shares arguably can also qualify as a major transaction. If, as often occurs, the company has no assets before the issue, then the consideration acquired, even if only $1, will constitute an acquisition of assets the value of which exceeds the greater part of the preacquisition assets of the company. As a major transaction, the issue of shares will require special resolution approval by the members under s 129. However, until shares have been issued, there exists no vehicle for the votes required for passage of the resolution. Further, the requirement for shareholder approval sits uneasily with s 41(a) pursuant to which the company must issue the shares specified in the application. In a multi-member company, the approval requirement enables one or more of the investors to interfere with the enforceability of a pre-incorporation agreement. Whilst approval is possible and trivial in the case of the one-person company, the requirement cannot be safely ignored in view of the absence of a specified liability consequence.

The pre-emptive right under s 45. The pre-emptive right in s 45 is relevant for those relatively few closely held companies with multiple unrelated shareholders. An obvious difficulty relates to fractional shares. Unless carefully planned, an issue subject to s 45 will result in entitlements to fractional shares, the voting rights of which are not regulated by the statute. This is particularly important for any member whose existing or prospective entitlement sits on or near one of the critical control percentages set by the statutory governance scheme or by a provision in the company's constitution. A second ambiguity involves the disposition of shares not taken up under s 45, i.e., whether they must be offered first to those members who exercised their entitlement. As a third problem, s 45 is difficult if not impossible to apply where the company has outstanding multiple classes of shares with different voting and distribution rights. The fourth and perhaps most serious difficulty concerns the relationship between s 45 and the regime for alteration of class rights under s 117. Section 117(3) arguably allows the board, with special resolution approval, to proceed without regard to s 45. This construction enables the board to bring a third party into the business over the objection of a minority shareholder provided that the board is ready to comply with the buyout obligation. This construction is not easy to reconcile with s 175 which makes failure to comply with s 45 an instance of prejudicial conduct. Whilst the result follows the approach of partnership law, it applies only in relation to members with holdings of 25% or less. The partnership solution is an elegant one which may appeal to some multi-member companies as a general solution to the admission of new members. However, it is uncertain whether or how ss 45 and 117 can be modified by the company constitution to duplicate that approach.

Incorporation agreements under ss 40 and 46A. The incorporation of a multi-member company is frequently preceded by an agreement amongst the investors. The agreement typically anticipates the use of a particular constitution, obligates each of the investors to subscribe for a specific number of shares and fixes the parties' participation in management. The most important feature of the agreement, concerning the subscription obligations, is subject to s 46A. If that section is construed as an exhaustive statement of the bases for liability for an issue under s 41(a), the subscription obligations will not be enforceable unless the incorporation agreement complies with s 182. However, compliance with s 182, which anticipates a different kind of pre-incorporation agreement, requires that the company eventually become a party to the agreement. This, in turn, makes the agreement subject to s 40(b) which entails compliance with s 47(1). Under s 47(1) the board must revisit the terms of the incorporation agreement and, if it finds them unfair, can and must refuse to proceed. This unsettles the ex ante enforceability and transactional function of the incorporation agreement.

Risks associated with nominal equity schemes. The 1993 Act encourages the use of nominally capitalised companies in that it has no minimum equity requirement like those found in EC jurisdictions and, with s 38, abandons the stated capital approach of the 1955 Act and some North American statutes. There are at least two liability risks associated with nominal equity schemes. One arises out of the recent decision in Re Wait Investments Ltd [1997] 3 NZLR 96. There a creditor brought an action under ss 320(a) and (c) of the 1955 Act against the directors of a $100 company. In awarding judgment to the creditor, the Court relied upon a number of factors including the amount of the obligation, the impecuniosity of the defendant and the nominal equity capital of the company. Whilst nominal equity has long figured in veil-piercing litigation overseas, Wait Investments Ltd appears to be the first time that a New Zealand court has identified it as a relevant factor in the application of s 320, whose prescriptions are adopted in ss 135 and 136 of the 1993 Act with an arguably lower threshold for liability. As a second risk, one also illustrated by overseas practice, nominal equity invites recharacterisation of shareholder debt as equity capital. Such recharactisation strips debt capital of its tax advantages, its priority in liquidation and its freedom from the capital maintenance constraints on distributions. In the event of liquidation, the principal will seek, under s 310, to offset the debt investment against obligations owed to the company, most commonly in the nature of salary advances. Nominal equity invites the liquidator to oppose set-off on the ground that the debt investment is in fact equity capital.

Section 47(3). Whether by design or inadvertence, it can easily happen that shares are first issued and then subsequently paid up other than for cash. For instance, in a one-person incorporation of a going business, the principal may enter her name in the share register prior to the transfer of assets to the company. This calls for compliance with ss 47(3) and (4) which require determinations, resolutions and certifications similar to those under ss 47(1) and (2). Noncompliance may leave the shares unpaid and, as illustrated by the recent decision in Waller v Paul (1997) NZCLC 261351, expose the shareholder to significant personal liability. As s 47(3) applies both to initial issues and those under s 107(2), the sequencing of the issue and performance of the consideration becomes critical.

Consequences of noncompliance. Noncompliance with the rules for share issues attracts a range of legal consequences. At the one extreme, noncompliance with s 40 makes the issue illegal and, in the absence of a court order under s 7 of the Illegal Contracts Act 1970, without legal effect. At the other extreme, noncompliance with ss 44 and 117 is stated as not affecting the validity of the transaction. Whilst the Act is silent on the consequences of noncompliance with the other rules, noncompliance can make the issue an unauthorised one. This can, in the case of a closely held company, usually be asserted by the liquidator or receiver against the shareholder under the proviso to s 18(1). Failure to comply with ss 45, 47 and 117 amounts to oppressive conduct under s 175 which potentially exposes directors to personal liability under s 174. Noncompliance with ss 43, 44 or 47 constitutes an offence which attracts both fines and eventual disqualification under s 383. As noted, overvaluation can lead to clawback liability under ss 297 and 298 and, in addition, can cause distributions to contravene the solvency test with the attendant personal liability under s 56.

Safe harbour precedents. In view of the consequences of noncompliance with the rules for share issues, advisors should have at their disposal safe harbour precedents for common incorporations. Unfortunately, the ambiguities and inconsistencies in the statutory scheme impede the formulation of such documents. The matter is further complicated by the statute's ministerial provisions. For instance, in the case of the one-person company, it is not clear whether or to what extent the definition of board in s 127 alters the minimum formalities required for effective decisions and compliance with s 189(1)(d).

Conclusion. The problems with share issues suggest that the 1993 Act is unsuited to the regulated environment. The rules comprise accountability measures which presuppose a separation of ownership and control, a feature found only in listed companies and the relatively few widely held unlisted ones. Compliance with the rules lies beyond the needs and capabilities of the principals of the closely held companies comprising around 99% of the registered entities. For one person companies, which constitute the large marjority of newly registered entities, the issue of shares requires no regulation whatsoever. The other closely held companies have at most a handful of members who also serve as directors of the business. In such entities, the issue of shares can be left to be regulated as a matter of contract. Issues by listed companies can be safely left to regulation by the Stock Exchange.

Share issues under the Companies Act 1993