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CORPORATE FINANCE LAW
CAPITAL MAINTENANCE
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5/18/2017
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2
1.Introduction ............................................................................................................................................... 3
1.1: Accounting concept: .............................................................................................................................. 3
2. Abstract: .................................................................................................................................................... 5
3. Methodology:............................................................................................................................................ 5
4. Subsections of capital maintenance ......................................................................................................... 6
5: Objective of capital maintenance: ............................................................................................................ 6
6. Function of capital maintenance: ............................................................................................................. 8
6.1. Financial Assistance: .............................................................................................................................. 8
6.2. Power of Company to repurchase its own shares: ................................................................................ 9
6.3. Buybacks: ............................................................................................................................................. 10
6.5.Case law: ............................................................................................................................................... 11
6.6. Payment of Dividends .......................................................................................................................... 11
7. Relevancy of capital maintenance presently: ......................................................................................... 12
8.Comparison of Capital Maintenance and Solvent Test:........................................................................... 14
9.Solvency test: ........................................................................................................................................... 14
10. Other ways to protect creditors instead of Capital Maintenance Doctrine ......................................... 15
10.1) Personal guarantees: ......................................................................................................................... 15
10.2) Forecasting the probable loses: ......................................................................................................... 15
10.3) Limited liability: ................................................................................................................................. 16
11.Conclusion .............................................................................................................................................. 17
pg. 2
3
1. Introduction
The Oxford English Dictionary defines the verb 'to maintain' as, 'to keep up, preserve, and cause
to continue in being ... to keep vigorous, effective or unimpaired, to guard from loss or
derogation1
The Doctrine of Capital Maintenance prohibits the Shareholders to take assets from the capital of
the company. Therefore this doctrine safeguards the claims of creditors, which is on the assets of
the company. The Capital maintenance Principle was developed in 19th century by judges who
explained it as a means of protecting corporate creditors against the extra risk associated with
limited shareholders liability. Sir George Jessel M.R gave remarkable judgment in Re Exchange
Banking Co, Flitcrofts case 1882. He said:
The creditors therefore, I may say, give credit to the capital, give credit to the company on the
faith of the representation that the capital shall be applied only for the purposes of the business,
and therefore has a right to say that the corporation shall keep its capital and not return it to the
shareholders
This image protecting the creditors from the risk that the shareholders take their investments out
of company and then creditors will bear the loss.2
Capital maintenance is an accounting concept based on the principle that income is only
recognized after capital has been maintained or there has been a full recovery of costs. Capital
1
Sir Jhon Armour, Share Capital and Creditor Protection: Efficient Rules for a Modern Company Law, The
Modern Law Review, Vol. 63, No. 3 (May, 2000), pp. 355-378, last accessed 17-05-2017, p. 12 available at,
http://www.jstor.org/stable/1097174?seq=1&cid=pdf-reference#references_tab_contents, last accessed 17-05-2017,
2
Ibid, p. 14
pg. 3
4
maintenance has been reached if the amount of a company's capital at the end of a period is
unchanged from that at the beginning of the period, with any excess amount treated as profit.3
3
http://www.investopedia.com/terms/c/capital-maintenance.last accessed at 18.5.2017
pg. 4
5
2. Abstract:
This research focused on the meaning, function and objective of the doctrine of capital maintenance
which means the capital of a company needs to be kept intact for there is a payment of the creditors and
retaining the capital is normally estimated to guarantee refund to the creditors. Any reduction of capital
can reduce the liability of members and as a result the position of the creditors can be in danger or at risk.
Therefore, an attempt has been made by this study to reveal the origin, objective and application of the
doctrine of capital maintenance to find out a way by which we can save the interest of the creditors as
3. Methodology:
pg. 5
6
Case law:
4
Ibid.
5
Romeo M Batista ,David Lim,Capital utilization in manufacturing(published for the world bank oxford university
press:456,457)
6
Richards A.Brealey,Steward C Myers, fundamentals of corporate finance(published by ADISON
WESLEY:234,233)
pg. 6
7
Avelong Barfor and Perion belonged to one person. In the course of doing business, the
owner could not make distribution to the shareholders of Aveling Barford. Aveling was
subsequently offered by the owner while conveying its property to Perion at an under
value. The court ruled in favor of the liquidator while condemning the conduct of the
former owner. UK company law case concerning reduction of capital. It held that a sale at
an undervalue of an asset was a dressed-up distribution. As the company did not have
distributable reserves, the sale was in consequence an unlawful reduction of capital.7
was deemed necessary in order to protect the interest of the company creditors. However,
the amendment in section 845 Companies Act 2006 now states that: "if a company is
executing the transfer of its asset where the value is at par or more than the book value, if
the company has profit to distribute, it may proceed with the transaction." Conversely, if
the company is executing the transfer of its asset where the value is less than the book
value, the calculation of the distribution will be based on the book value.
Companies Act 2006 stipulated that the company must prove that: it has the ability to pay
its debt and that the company will be able to pay its debt as it arises for the next twelve to
twenty four months. Amour argued that if a company is unable to discharge its duties by
meeting the companys liabilities, and resort to reducing its share capital or make
distribution from capital instead of doing that through distributable profits, the companys
creditors investments in the company are already exposed to too much risk.
7
Aveling Barford Ltd v Perion Ltd 1989 BCLC 626
pg. 7
8
i. Imposed a prohibition on a company to acquire its own shares or redemption of its own
shares or those of its holding company( see section 95 of company ordinance 1984)8
ii. Prohibition on a company to give financial assistance for the purchase of its own shares
or its holding company( see section 95 of company ordinance 1984)
iii. Prohibition to pay dividends which reduce the capital. But dividends must be paid out of
distributable profits. ( see section 249 of company ordinance 1984)9
iv. Court sanction is required for the reduction of capital (see section 96 of company
ordinance 1984)10
8
ibid
9
Jhon F Farrar, Company Law,(London: Butterworth & Co Ltd, 1985),45.
10
Capital maintenance regime Available at www.cr.gov.hk/en/publications/docs/062008_ch3-e.pdf last accessed
18-5-2017
11
See Section 3(a) of company ordinance 1984
12
See Section 2(35) of companies ordinance 1984
13
See section 677 of companies act 2006
14
See section 2 (8) of company ordinance 1984 "company limited by shares" means a company having the
liability of its members limited by the memorandum to the amount, if any, unpaid on the shares respectively held by
them
15
See section 2(28) of companies ordinance 1984
16
See section 3(b) of companies ordinance 1984
17
See section 2(30) of companies ordinance 1984
18
See section 2(34) of companies ordinance 1984
pg. 8
9
who was not a director of the company, but it excludes all director of the company for
purchasing of shares company or its subsidiary or holding company. 19
19
Amar V.Bhide,The origin and evolution of new business(published by oxford university press:34,35)
20
See section 2(20) of companies ordinance 1984
21
See section 2(36) of companies ordinance 1984
22
The extra value of a share in relation to its value when it was issued. Available at
http://dictionary.cambridge.org/dictionary/english/share-premium last accessed 18-5-2017
23
Section 724 of companies act 2006 limited company, where it makes a purchase of its own shares, may
subject to conditions, hold the shares or deal with them. Where shares are held by the company, the company must
be entered in its register of members as the member holding the shares. These are treasury shares.
24
William L.Megginson,Corporate Finance Theory(published by Addison Wesley Longman:78,79,67,69)
pg. 9
10
purpose by the company. Importantly, it also provides that the voting rights and the right to
receive dividend of the shares so purchased shall remain suspended as long as they are held as
treasury shares by the company itself. A hefty fine of up to thirty million rupees has been
provided for violation of the law in addition to liability for any losses or damages caused by such
violation.25, if Capital Re-purchase account becomes paid-up capital26 of company then
company can repurchase its share capital, company must maintain the register of shares and
includes no of shares, consideration paid for the shares, mode of purchase, date of cancellation of
such shares; return from purchase of shares along with the declaration of solvency shall be filed
with the commissioner and registrar within 30 days; if company not give declaration to the
registrar and commissioner then liable to a fine of 30 million rupees.
6.3. Buybacks:
Refer to the repurchasing of shares of stock by the company that issued them. Essentially,
a buyback occurs when the issuing company pays shareholders the market value per share and
re-absorbs that portion of its ownership that was previously distributed among public and private
investors. Since companies raise equity capital through the sale of common and preferred shares,
it may seem counter-intuitive that a business might choose to give that money back.27
relates to when the company intends making a distribution to its shareholders but lacking
adequate reserve to execute it. For such reason, companies can decide to either reduce or cancel
its share capital or some of its reserves28. Then the doctrine was amended and after that the
companies have been empowered to reduce their share capital if need be. In the amendment, a
25
Available at www.secp.gov.pk/news/pdf/news_09/ordinance_act.pdf last accessed 18-5-2017
26
the money that a company is paid for its shares by investors and for which complete payment has been
received: available at http://dictionary.cambridge.org/dictionary/english/paid-in-capital last accessed 18-5-2017
27
ibid
28
William L.Megginson,Corporate Finance Theory(published by Addison Wesley Longman:78,79,67,69)
pg. 10
11
company can reduce its share capital by the joint resolution of the company directors in
Section 96 of Companies Ordinance 1986 says that Company limited by shares reduce its share
capital but take prior confirmation from court, and if so authorized by its articles 29 reduce by
special resolution30 reduce its share capital. In case of private company, it is possible to reduce
capital by special resolution by mere a solvency statement but public company must confirm it
by court31. Company reduce its share capital by
Diminish the liability on any of the shares of the company in respect of share capital not
paid up
The company with and without reducing liability on any of its shares, cancel any paid up
share capital which is lost or there is no assets available on paid up shares.
To repay any paid up share capital in excess of the companys needs.32
assets is not less than the aggregate of its called up share capital and distributable reserves. This
results in a requirement for public companies to reduce the amount of their net realized profit
available for distribution by the amount of its net realized losses, when calculating the amount
for distribution. As this does not necessarily apply to private companies. He statutory rule on
29
Section 2(1) of Companies Ordinance 1984
30
Section 2(36) of Companies Ordinance 1984
31
Nicholas Bourne, Bourne on Company Law, Sixth Edition Published 2013 by Routledge (2 Park
Square, Milton Abingdon, Oxon) Ch. 9, P. 138
32
Moshe Ben Horin,Essientials of corporate finance (published by:Allyn and Bacon )
33
Ooregum Gold Mining Co of India v Roper [1892] AC 125
pg. 11
12
distribution empowers companies to make distribution only when, after due consultation with the
company directors, consideration shall be made whether or not distribution are to be made
Under section 249 of Companies Ordinance 1984 dividends must be paid out of profits of
Company, if there is no distributable profits34 then no dividend paid to the shareholders.
These above provisions relating to capital maintenance is used to protect creditors against the
risk of limited shareholders liability.
According to Alan & John (2010):
the statutory role on distribution which is enforced under the doctrine of capital maintenance, in
the context of companies Act 2006; it is unlawful for a company to execute a distribution from a
capital. The statute further states that if the companys relevant account indicates that there is
enough fund to carry out distribution, the company directors must ascertain that making such
distribution will not affect the business operations of the company. Based on that, it is quite easy
This is a fundamental principle embedded in English Law and has been legislated through the
Companies Act 1985 and more recently The Companies Act 2006, which amended the original
doctrine. Business transactions have continued to undergo evolution thereby rendering the
protection afforded by the conditions of capital maintenance doctrine insufficient to meet modern
needs. Though the Company Act 2006 aims to modernize the doctrine; it still remains unfit for
its purpose.
34
The amount of a companys profit that is available to pay dividends to shareholders in a particular period.
Distributable Profits= Profits-(Dividend paid + losses) Available at
http://dictionary.cambridge.org/dictionary/english/distributable-profit last accessed 18-5-2017
pg. 12
13
Most companies only have a small issued share capital. Out of a total of over 662,000 live
companies incorporated in Hong Kong which have issued capital in Hong Kong Dollars HKD as
at end of April 2008, around 80% have no more than HKD 10, 000 issued share capital and
Some have also considered the capital maintenance rules are too much and unnecessary complex,
usually not fulfill its purpose and somewhat overtaken by their exceptions36
Developed countries like Singapore, UK and Australia have reformed their capital maintenance
rules and some countries moved towards Solvent test approach like USA and New Zealand37.
Three types of solvency tests are used in Company law
a test of whether a company can pay its debts as they come due (the ability -to-pay
solvency test, sometimes referred to as cash-flow solvency or equitable solvency)
a test of whether the fair value of a firm's assets exceed the face value of its liabilities
(the balance-sheet solvency test, performed on either a going- concern or liquidation
basis),38
The cash flow test basically requires the company to be able to meet all debts as they fall due,
whilst the balance sheet solvency test requires that liabilities must not exceed assets.39
Majority of directors are confirming that tests are met and they give a solvency certificate. Civil
liability is usually provided to give the right of recoupment by the company of the unauthorized
distribution from directors or shareholders. In addition, criminal liability is imposed on a director
who signs a certificate knowing that it is false or misleading in a material particular40
35
Capital maintenance regime Point 3.6, Available at www.cr.gov.hk/en/publications/docs/062008_ch3-
e.pdf last accessed 18-5-2017
36
Ibid. point 3.7
37
Ibid point 3.8
38
J.B. Heaton Solvency Tests The Business Lawyer, Vol. 62, No. 3 (May 2007), pp. 983-1006
Published by: American Bar Association, Available at http://www.jstor.org/stable/40688428, last accessed
17-05-2017. Page.2
39
Capital maintenance regime Point 3.10, Available at www.cr.gov.hk/en/publications/docs/062008_ch3-
e.pdf last accessed 18-5-2017
40
Capital maintenance regime Point 3.10, Available at
www.cr.gov.hk/en/publications/docs/062008_ch3-e.pdf last accessed 17-5-2017
pg. 13
14
9. Solvency test:
The balance sheet test
the process of ascertaining, from a company'sbalance sheet, what would be available to member
s of the company were it to be immediatelywound up, with the assets being sold and the liabilitie
s discharged. If, on examination, thecompany is found to be insolvent (i.e. liabilities exceed its as
sets), it is an offence for thedirectors to permit it to continue trading. Any debts incurred by the c
41
Capital maintenance regime Point 3.12 (a), Available at
www.cr.gov.hk/en/publications/docs/062008_ch3-e.pdf last accessed 18-5-2017
42
Ibid. point 3.12(b)
43
See section 56(1) of the NZCA. There are however safeguards that shareholders who received the
dividends in good faith and who have altered their position can keep their dividends. By comparison, under the USs
Revised Model Business Corporations Act, directors are primarily liable for the amount in excess of a lawful
distribution.
44
Ibid point 3.12(c)
45
Ibid point 3.12(d)
pg. 14
15
ompany by continuedtrading after the directors are aware that the company is insolvent become t
UK and Singapore recently started court-free process for reduction of capital which is used in
solvency test which is faster and cheaper. But in Final Report UK argument that decisions on
court confirmation provides certainty as to the legality of the transaction and therefore still had
its value47
Some creditors may also perceive a solvency declaration by the directors as offering lesser
protection for them than the courts oversight.48
46
Ibid point 3.19
47
Ibid point 3.22
48
Ibid point 3.24
49
Peter O. Mü lbert, A Synthetic View of Different Concepts of Creditor Protection, or: A High-
Level Framework for Corporate Creditor Protection, European Business Organization Law Review / Volume null /
Issue 01 / March 2006, pp 357 408, published online 21 June 2006, Available at
http://journals.cambridge.org/abstract_S1566752906003570 last accessed 18-5-2017, point 5.1,pp 15.
50
Ibid
pg. 15
16
unable to pay the amount of money to creditors51. Therefore company must restrict the
limitations. Creditors will prefer a lower debt-equity ratio (the proportion of contributions of
owners and creditors) and conversely for a given ratio, shareholders will prefer the company to
pursue more risky projects than creditors will favor. Furthermore, with a company moving more
and more towards insolvency, the divergence becomes ever more pronounced52. Creditors will
also suffer loss due to directors poor management and violation of duty of care and duty of
loyalty. Creditors can protect themselves by taking guarantees from shareholders and directors. 53
51
As mentioned above in capital maintenance
52
Peter O. Mü lbert, A Synthetic View of Different Concepts of Creditor Protection, or: A High-
Level Framework for Corporate Creditor Protection, European Business Organization Law Review / Volume null /
Issue 01 / March 2006, pp 357 408, published online 21 June 2006, Available at
http://journals.cambridge.org/abstract_S1566752906003570 last accessed 18-5-2017, point 5.3.1, pp 18.
53
Ibid point 5.3.2, pp 19.
54
E.g. Doctrine of Pari Passu in which equal treatment given to creditors at the time of winding-up of
companies. Available at http://www.bis.org/publ/bppdf/bispap72u.pdf last accessed 18 May 2017
55
Peter O. M & Uuml;lbert, A Synthetic View of Different Concepts of Creditor Protection, or: A High-
Level Framework for Corporate Creditor Protection, European Business Organization Law Review / Volume null /
Issue 01 / March 2006, pp 357 408, published online 21 June 2006, Available at
http://journals.cambridge.org/abstract_S1566752906003570 last accessed 18-5-2017, point 5.3.3,pp 20
pg. 16
17
11. Conclusion
Capital maintenance provisions56 protects creditors and safeguard their claims 57
Creditors and
other stakeholders need guarantee that their investments in these companies are secure from the
unpleasant unexpected of business operations. The doubts of creditors and the expectations and
limitations of shareholders are therefore addressed by the doctrine of capital maintenance under the
companies Act 2006. The modus operandi(a particular method of doing something) of this doctrine
touched many areas of company accounting practices; the perceived Creditors and other stakeholders
need guarantee that their investments in these companies are secure from the unpleasant unexpected of
business operations. The doubts of creditors and the expectations and limitations of shareholders are
therefore addressed by the doctrine of capital maintenance under the companies Act 2006. The modus
operandi(a particular method of doing something) of this doctrine touched many areas of company
accounting practices; the perceived protection it offers and the workability of the principle contained in
the doctrine and to a large extent, companies Act 2006.
But some countries moved towards solvency test approach58. Therefore, it is better to protect
creditor by applying limitations on gifts, distribution of profits, reduction of capital and buy-back
of shares59. And creditors can also protect themselves by self help60.
:
56
See section 95,95A,96,249 of companies ordinance 1984)
57
See above at page 1
58
see above at page no 5
59
see section 95,95A,96,249 of companies ordinance 1998
60
see above at page 7
pg. 17