2.3 Liquidity of withdrawable shares
Withdrawable shares provide investors with an exit route from investment not available to investors in transferable shares. This liquidity is the main reason why the society form is so suitable for a community business with many investors. The best way that liquidity can be achieved for investors with transferable share capital, is for the enterprise to be large enough to be listed on a stock exchange. A stock exchange works when there are sufficient buyers and sellers interested in an enterprise’s shares to generate liquidity. Usually, an enterprise needs to have issued between £10m and £25m in share capital before it achieves liquidity on a stock exchange. In smaller enterprises liquidity is usually provided by selling all the shares to another person or enterprise, but such decisions can only easily be taken if ownership of the enterprise is restricted to a handful of shareholders with majority control. Alternatively, some enterprises engage in matched bargain services, whereby a third party service provider, matches buyers and sellers of transferable shares, on behalf of the enterprise.
Withdrawable share capital solves the problem of liquidity for investors, but it does so by creating a responsibility for societies to provide that liquidity. This is a major difference between a society and a company, which has no responsibility to provide liquidity for shareholders unless it has issued redeemable shares.
The FCA’s registration guidance, published in November 2015, says that a society should only allow the withdrawal of shares if “it has trading surpluses that match or exceed the value of shares involved, and the directors believe that the society can afford to pay its debts taking into account all of its liabilities (including whether it will be able to pay its debts at the date of withdrawal, and for a year after that, any contingent or prospective liabilities,) and the society’s situation at the date of the transaction”.
This is the first time that the FCA has made a public policy statement regarding the withdrawal of share capital. The Co-operative and Community Benefit Societies Act 2014 has little to say about the withdrawal of share capital. However, Section 124 of the Act makes members fully liable for the value of their share capital held up to one year prior to the society being wound up, in the event that the society becomes insolvent, even if the member has withdrawn their share capital and ceased to be a member of the society. This places a duty on directors not to allow the withdrawal of share capital if there are grounds to believe that society may become insolvent. The withdrawal of share capital should be restricted or suspended if the liabilities of the society exceed its assets, or are in danger of becoming so in the next twelve months.
The main indicator that a society may be insolvent is if it has accumulated losses or negative reserves. Any amount of negative reserves means that the society would be unable to pay the full paid-up value of its share capital were the society to cease trading. In such circumstances a society should either suspend withdrawals, or only allow discounted withdrawals if its rules make provision for such an arrangement (see Section 3.2.9). If a society’s negative reserves exceed its total share capital then it is insolvent, and it should cease trading, unless the directors have grounds for believing that the society is trading profitably and that it can reduce its accumulated losses.
The FCA requirement that trading surpluses should match or exceed share withdrawals is taken to mean that a society should not allow withdrawals if the society is, or could become, insolvent, unless the society’s rules make provision for restricted withdrawals in such circumstances. This interpretation of FCA policy would mean that withdrawals could also be financed by the inflow of new share capital, the reinvestment of share interest and dividends by members, and by reductions in the capital requirements of a society.
An important distinction needs to be made between solvency and liquidity. The mere fact that a society has cash to pay for withdrawals does not mean that it is solvent, or that withdrawals can be allowed. Equally, a solvent society with accumulated profits may find itself unable to allow withdrawals because it lacks the available cash to do so. A solvent society has a duty to maintain a cash position that allows it to fulfil the terms and conditions of its share capital.
A society can manage its capital liquidity in several ways. It has the powers to set terms and conditions for the withdrawal of share capital in its rules (see Section 3.2.9). This usually includes rules that require members to give a set notice period, from one week to one year, of their request to withdraw some or all of their capital; rules that cap the total amount of share capital that can be withdrawn in any one financial year; and rules that allow the society to discount the value of its share capital. In addition, a society can adopt a rule which gives the board the power to suspend withdrawals. This rule is mandatory if the society is to present its share capital as an asset on its balance sheet.
Whichever method of providing for liquidity is used, the society will need to establish cash balances capable of meeting requests for withdrawal.
There are five main ways in which a society can provide liquidity for members. All of these methods rely on the society being solvent in the first place. Before issuing community shares, a society should decide which of these methods it will use, and ensure that this is reflected in its business plan and share offer document. This, in turn, will depend on the starting point of the society, its trading activities, objects and purpose. The methods can be used singly or in combination.
- Raising new share capital: This can be achieved through an open offer, enabling the society to recruit new members and raise new share capital. Open offers work best where the community is already engaged as customers, volunteers, employees, or suppliers, making the invitation to become a member and investor all the more appealing. Existing members can also be encouraged to invest new additional capital.
- Reinvestment by existing members: It is common practice for societies to credit the share accounts of existing members with share interest and/or dividend payments, thereby reinvesting this money in the share capital of the society. Depending on the scale of these payments, this can be a significant source of new capital. The consequent growth in value of a member’s share account is the closest a member will get to achieving a capital gain in a society.
- Redemption from reserves: A profitable society that is accumulating reserves may use these reserves to finance share withdrawals and reduce its liability for share interest.
- Reduction in capital requirements: Some societies, especially those in the community energy sector, plan to reduce their capital requirements over the lifetime of their fixed assets, and to wind up the society at some pre-determined point in the future. In such circumstances, it is reasonable to allow share capital withdrawals in line with the depreciation of the society’s fixed assets.
- Replacement with loan capital: Solvent societies that have reinvested reserves into business assets and do not have cash to finance withdrawals may decide to borrow capital to provide liquidity.
If the society is charitable, consideration should be given to the nature of funds held by the charity when considering share withdrawability. Withdrawals must not be funded through restricted funds, which are held for specific purposes only.
Withdrawals should always be funded from unrestricted or “general” funds, which can be spent at the charity’s discretion. Where unrestricted funds have been designated for a particular purpose, then again we would not recommend their use for withdrawal of share capital if other funds are available.
If no other funds are available then the society should not be allowing withdrawal until the funding position has improved.*
Most new societies suspend the withdrawal of share capital for an initial period of up to five years. It can be justified by the society’s financial projections and when it anticipates having cumulative retained profit. However, there are drawbacks to suspending withdrawals for long periods, especially if this means that a society is unable to make an open offer and to recruit new members (see Section 4.6).
It is possible for a society to be over-capitalised, meaning that members have invested more share capital than a society needs for its business activities. This might come about if a society is running an open offer (see Section 4.6) which attracts more share capital than it needs, or it is working to a business model based on a reducing capital requirement, as described above. If the amount of money available to pay interest on share capital has to be distributed to a larger amount of share capital than planned, it can result in lower interest rates, which may be less than the interest rates promoted to members to attract the capital in the first place. In such circumstances, it would be prudent for the society to return some of the share capital to members.
The Co-operative and Community Benefit Societies Act 2014 makes no provision for over-capitalisation or the circumstances under which a society may return share capital to members without this being requested. The FCA has registered societies with rules that make specific provisions for returning share capital to members. Other societies have published share offer documents that make it clear that share capital will be returned to members according to a specific schedule as the society’s capital requirements decline. This is not uncommon in the community energy sector, where a society has adopted a fixed lifetime linked to the expected life of its capital installation and the associated funding and site agreements. The proposed terms for returning share capital should be clearly set out in the offer document, including a description of how this interacts with a member’s right to withdraw share capital outside of this proposed schedule.
As with any other contractual matter covered in a share offer document, if the society decides to change these terms and conditions, it should first seek the approval of members. The same principle applies to a society that wants to return share capital to members but has made no provision for this in its rules or offer documents. In addition to the above requirements, capital should only be returned to members if a society has sufficient reserves to cover any long-term liabilities and the society does not risk becoming insolvent.
*Definitions from the Charity Commission website (England & Wales) guide to developing a reserves policy:
Restricted funds: funds subject to specific trusts, which may be declared by the donor(s) or with their authority (eg in a public appeal) or created through legal process, but still within the wider objects of the charity. Restricted funds may be restricted income funds, which are spent at the discretion of the trustees in furtherance of some particular aspect(s) of the objects of the charity, or they may be endowment funds, where the assets are required to be invested, or retained for actual use, rather than spent.
Unrestricted funds (including designated funds): income or income funds which can be spent at the discretion of the trustees in furtherance of any of the charity’s objects. If part of an unrestricted income fund is earmarked for a particular project it may be designated as a separate fund, but the designation has an administrative purpose only, and does not legally restrict the trustees’ discretion to spend the fund.