Defective share buybacks: why they go wrong and how they can be rectified?

Share buybacks enable a company to purchase shares from its shareholders. Companies will typically fund buybacks out of distributable profits, but a separate procedure also allows buybacks to be financed out of capital.

The buyback process can be useful for companies looking to efficiently return value to shareholders and adjust their capital structure. It also provides an exit route for shareholders who wish to leave the company, perhaps on retirement or where there are no third-parties willing to acquire their shares.

However, if a buyback is carried out in breach of the strict legal requirements of the Companies Act 2006 (the Act), the buyback will be defective meaning that the shares are not repurchased and remain in the hands of the selling shareholder. To fix the issue, the parties must embark on a rectification process, with consequences for both the company and selling shareholder.

What can go wrong?

A share buyback will be void if it is carried out in breach of the Act. These regulations are complex and there are a number of common pitfalls:

• A buyback carried out in breach of any restrictions or prohibitions contained in a company’s articles of association is not permitted.

• A written buyback contract between the company and selling shareholder is required and must be approved by the shareholders in advance of the buyback. The absence of a buyback contract or failure to obtain shareholder approval are common causes of a defective buyback.

• Where the buyback was intended to be funded out of distributable profits, there were insufficient distributable profits available to pay the purchase price.

• The shares must be paid for at the time of purchase so the buyback will be void if the purchase price is structured differently (e.g. paid later, paid in instalments or left outstanding as a loan).

• The company will also need to ensure that stamp duty is paid to HMRC, necessary filings are made at Companies House, and the buyback is recorded in the statutory books. Failure to do so may also affect the validity of the buyback.

Legal and tax consequences

A defective buyback is problematic for both the company and the selling shareholder. The shareholder will remain the legal holder of the shares since the date of the defective buyback and the company could be liable to the shareholder for unpaid dividends (potentially with retrospective effect). The company may be faced with a costly and time-consuming exercise to rectify the buyback, and the directors may be exposed to liability relating to the defective transaction.

In addition, the question of how the original payment is treated is likely to have legal and tax consequences. For example, on a recent transaction involving a defective buyback, the payment was characterised as an interest-free loan paid to the shareholder. Because the company involved was a close company (i.e. controlled by a small number of people), a 33.75% tax charge arose under s.455 of the Corporation Tax Act 2010 because the ‘loan’ was not repaid within nine months and one day. The tax position will be fact dependent and careful analysis will be required to ensure the company and seller understand their positions.

How to rectify a share buyback

Rectifying a defective buyback will be crucial. If the buyback was discovered as part of an M&A due diligence process, rectification will almost certainly be a pre-completion requirement of the buyer (and any buyer might want additional contractual protection in its acquisition documents). The parties therefore will need to quickly agree the most appropriate method of rectification which will be dependent on the factual circumstances.

A common approach is to carry out the share buyback again, ensuring it complies with the requirements of the Act. The shareholder’s name will be restored to the company’s register of members, and a new buyback contract will need to be signed by the seller and the company. The contract may include a tax indemnity from the company to the shareholder to cover any additional tax liability imposed on the shareholder as a result of rectifying the buyback. This approach is popular if the buyback was carried out relatively recently and the selling shareholder can be traced and is willing to sign the new buyback agreement.

A void share buyback may also be rectified by cancelling the shares. Usually, a capital reduction of this nature will follow the solvency statement procedure, although private companies may also carry out a reduction of capital that is approved by the court. The capital reduction route doesn’t require participation from the selling shareholder which makes the process advantageous if the buyback was carried out several years ago or the selling shareholder is uncooperative or cannot be traced.

The Birketts view

There are a number of reasons why buyback go wrong and the rectification process is extremely nuanced and fact dependent. All rectification exercises come with tax complications, so it is crucial to understand exactly what went wrong and what the tax impact could be on both the company and the selling shareholder.

At Birketts, our approach is always informed by our client’s situation. Whether rectification is best achieved by a corrective buyback or by reducing the company’s capital, our specialist corporate and tax lawyers have a breadth of recent experience to ensure the best outcome for our clients with the minimum possible legal and tax consequences.