Legal responses to corporate undercapitalisation : towards a proactive approach?

Inaugural lecture--Department of Mercantile Law, University of Johannesburg, 19 October 2011@@The ability to mobilise capital by attracting investments from the public was one of the driving forces in the development of the modern company. Companies finance their business operations through a combination of equity and debt. The choice between equity and debt financing depends on a variety of factors ranging from macro-economic factors such as the relative abundance or scarcity of capital, the costs of raising different types of financing and the tax treatment of debt and equity financing. A notion of undercapitalisation is recognised in several disciplines of the law, including tax law, company law and corporate insolvency law. As these disciplines have different purposes they employ different definitions of and attach different consequences to undercapitalisation. They employ mostly reactive or ex post strategies. Yet the recognition of the concept implies that there is an ideal standard according to which corporations should be capitalised - an idea of adequate capitalisation. The purpose of this lecture is to analyse some of these responses in search for common ground that may serve as the basis for a more proactive solution or guiding principle. Company law does not generally prescribe to what extent equity and debt financing should be relied on or, for that matter, the value of the total assets that a company should have. Some jurisdictions do prescribe a minimum capital or pay attention to the manner in which a company is to be financed, but such measures tend to have a limited impact beyond the incorporation phase of a company. Limited attempts are also made to scrutinise proposed financing methods when the continuance of a distressed company is under consideration. Although undercapitalisation is an important factor in imposing personal liability for the debts of a company based on the so-called veil-piercing cases, it is not generally regarded as an independent ground for the disregarding of corporate personality. This complicates formulation of a proactive approach. In international tax law, transfer pricing rules function as anti-avoidance measures that prevent the abnormal allocation of income and expenses between related or connected persons aimed at obtaining a tax benefit. These measures include thin capitalisation rules targeting the use of disproportionate levels of debt in relation to equity. They prevent the deduction of excessive interest payments in respect of debt financing by connected persons. While they treat debt financing as if it was in fact equity financing, this is done only in relation to the tax consequences. Nevertheless, it seems that tax law can provide useful guidance in the formulation of a concept of inadequate capitalisation. Corporate insolvency law provides several responses to undercapitalisation, including the equitable subordination of debt and the recharacterisation of debt as equity. While the requirements for and consequences of these two responses differ, both apply in respect of financing provided by insiders such as holding companies, controlling shareholders and certain creditors. The degree of correspondence between the types of financing subjected to these insolvency solutions and the transactions targeted by thin capitalisation rules is evident. The regulation of insider loans thus appears to be a good starting point in addressing the problem of corporate undercapitalisation. Insolvency law in Germany and in the United States of America provide useful guidance for the design of a South African approach.