In recent years, we have increasingly read in the press about board members being ordered to pay damages due to insufficient equity in limited companies. But what does this actually mean?
What is equity?
When a limited company is established, the shareholders contribute share capital. After the company is established, this share capital constitutes the company's equity. It is this money that constitutes the company's risk capital. In principle, the shareholders do not contribute more than the share capital.
Let us imagine that the limited company is established with NOK 100,000 in share capital. The equity capital is then NOK 100,000.
In its first year of operation, this company has a negative result of NOK 20,000. At the end of this year, equity is therefore reduced by NOK 20,000 to NOK 80,000.
However, in the second year of operation, the company makes a profit of NOK 100,000, and the shareholders do not take any dividends. This increases the equity to NOK 180,000.
However, in its third year of operation, the company posts a negative operating result of NOK 300,000. This results in negative equity of NOK 120,000.
Why are the equity requirements so strict?
As long as equity is positive, it is the shareholders' money that is used as risk capital. When it is negative, the shareholders' money is essentially gone. Then it is the creditors' money that is at risk. This is a strict situation because you are running a business with other people's money. This is often referred to as operating at the creditors' expense.
When is equity too weak?
The Companies Act stipulates that a company must at all times have adequate equity capital based on the risk and scope of its activities. It is easy to understand that a larger business needs more equity capital in order to be financially sound. The risk associated with the business can also vary greatly. A construction company that enters into complex fixed-price contracts typically has a high level of risk. This is because, for example, a miscalculation in the tender or unforeseen circumstances later on can have major consequences for the outcome of the project. A business that only sells hours and invoices on an ongoing basis according to time spent will have less risk.
It is obvious that equity is not defensible when it is negative, but it may also be indefensible before this point. This must be assessed specifically on the basis of the factors mentioned above.
What are the duties of the board?
Firstly, the board is obliged to ensure that the accounts are correct so that it is possible to monitor the development of equity. If it must be assumed that the equity is not sound, the Companies Act stipulates that the board must immediately address the matter. The board is then obliged to convene a general meeting to propose measures. Equity can typically be strengthened through a share issue, for example, so that current shareholders increase the share capital.
What do board members risk?
If the board neglects its duty to keep itself informed about the company's position through accurate accounting, or if the equity capital is not adequate, individual board members may face claims for compensation from those who lose money.
Lawyer (H)
The author of this article is a lawyer with the right to appear before the Supreme Court. He regularly works on cases concerning company law and liability under the Companies Act.