One of the most common mistakes we see as corporate lawyers is when a company has tried to implement what is commonly referred to as “alphabet shares”, but doesn’t quite get it right.
Basic share rights
If a company has one class of shares these are commonly called “Ordinary Shares”. An ordinary share typically has 3 rights attached to it as follows:
- The right to share in any surplus capital (this is essentially what is left over if the company turned all its assets into cash and paid off all of its liabilities or the sale proceeds if the company was sold to a third party).
- The right to a dividend (a dividend is surplus profits made by a company which are then paid out, in whole or in part, to the company’s shareholders).
- The right to attend and vote at a meeting of a company’s shareholders.
Where a company only has one class of share then the above rights are usually pro-rata. As such if you have a 10% shareholding you would essentially get 10% of any sale proceeds, get 10% of any dividends paid to the shareholders and carry 10% of the votes at a shareholder meeting.
What are alphabet shares?
Alphabet shares are where one shareholder will hold A Ordinary Shares (A Shares), another will hold B Ordinary Shares (B Shares), another will hold C Ordinary Shares and so on. By drawing a distinction between an A Share and a B Share you can start varying the basic rights set out above so they apply to one class of shares and not another.
For example, if a company had A Shares and B Shares it could be that the A Shares and B Shares rank equally (i.e. pro rata) for surplus capital/sale proceeds, the A shares have full voting rights but the B Shares are non-voting shares and differing dividends can be declared across the A Shares and B Shares (meaning dividends don’t have to be paid out on a pro-rata basis).
Why implement alphabet shares?
More often than not the main driver for implementing alphabet shares is tax efficiency by allowing a company to pay out different dividends to different shareholders on a non-pro-rata basis such that a 10% shareholder could receive say 40% of any dividend declared. By way of illustration, if a husband and wife own shares in a company 50/50, if one is a higher rate taxpayer and the other is a lower rate taxpayer then it might be tax advantageous to pay a bigger dividend to the lower rate taxpayer. In a situation where there are no alphabet shares then any dividend would have to be paid pro-rata to shareholdings (i.e. 50/50) and more tax would potentially be payable.
So what can go wrong?
When implementing alphabet shares the most common mistake we see is companies who have simply converted their existing Ordinary Shares into A Shares, B Shares etc or issued new A Shares, B Shares etc without doing anything else such as updating the company’s Articles of Association (Articles) (essentially the company’s constitution as filed at Companies House).
By default, all shares in the capital of a company will rank equally unless otherwise provided in the Articles or the terms of issue of the shares. As a result, if a company has simply converted some Ordinary Shares into alphabet shares or issued new alphabet shares but has not specifically set out the different rights attached to these shares (e.g. the right to receive differing dividends) in an updated set of Articles (or the resolution creating those shares) then the alphabet shares all rank equally, despite having different denominations, which means they need to be treated equally (i.e. pro rata) when it comes to voting, dividends and capital. Simply saying that the different classes of alphabet shares have a differing dividend right on Companies House forms such as the annual Confirmation Statement or any other form of “statement of capital” probably does not go far enough to draw a sufficient distinction under common law.
What are the consequences of getting it wrong?
If a company has issued different classes of alphabet shares but hasn’t updated its Articles to explicitly allow for non-pro-rata dividend payments across these classes, and subsequently pays dividends in this manner, then the company may have paid an illegal dividend.
If a company declares and pays an illegal dividend, the directors may face consequences. This is because they may be in breach of their legal duties to the company and hence could be personally responsible for repaying the dividend. This result could apply even if they aren’t shareholders and didn’t receive any of the dividends in the first place.
What’s more, if you’re considering selling your company in the future, be aware that potential buyers typically identify issues like the payment of illegal dividends during their due diligence investigations. This could not only delay the transaction but might also require the shareholders to offer specific assurances and promises to pay against any future liabilities stemming from those past illegal dividend payments.
Next steps
If your company has alphabet shares, it’s essential to check if your Articles have clear provisions detailing the distinct rights among these share classes and specifically permitting variations (such as different dividends) across them. Merely stating the company has A Shares and B Shares isn’t sufficient. If this clarity is lacking, then this is something worth rectifying sooner rather than later.
If you’re considering implementing alphabet shares then speak to a specialist solicitor, such as the corporate/commercial team here at Gorvins. Our expert team will help you make the right provisions for your company and ensure everything is done correctly right from the outset.
Call us on 0161 930 5151 or e-mail us at commercialteam@gorvins.com