1. MAINTENANCE OF CAPITAL VIS-A-VIS CREDITORS’ PROTECTION IN A
LIMITED LIABILITY COMPANY
Name: Preetesh Raman Singh
Address: Preetesh Raman Singh,
IIIrd year, B.A.LLB (Hons.), Room no.218, S. Radhakrishnan Halls of Residence,
National Law University, NH-65, Mandore,
Jodhpur- 342304 (Raj.)
Telephone Nos: Mobile. 09950404592/011-22783204
University nos. +91-291-2577530/2577526
Email: preetesh.raman@gmail.com
Name and Address of college/university: National Law University
NH-65, Mandore,
Jodhpur- 342304.
Student identification number/ Roll No: 749 (UG/2009)
Course: 3rd year, B.A.(Hons.) LLB.(Hons.)
Academic Year: 2011-12
Word Count: 2,200 (approx.)
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2. MAINTENANCE OF CAPITAL VIS-A-VIS CREDITORS’ PROTECTION IN A
LIMITED LIABILITY COMPANY
ABSTRACT
Doctrine of maintenance of capital emerged as a fundamental principle of
Company Law in 19th century in common law countries. After its inception the
same principle was incorporated in Indian law. This principle lays down certain
restriction over a company to deal freely with its capital. A company is prohibited
from reducing its capital from certain amount. Indian market has witnessed
drastic change since the independence of India. Commercial activities and profit
making tendencies have increased. Companies need capital for their business and
but they are helpless. This paper delves into the provisions as well as solution to
this crisis.
INTRODUCTION
Most provisions of the Indian Companies Act, 1956 have followed the format and plan of British
Company Law. Any company which is limited by shares is subjected to certain restrictions
regarding its authorized or called up share capital. Company cannot use its capital irrationally
prejudice to the creditors. Sometimes floating charges are created on company’s assets and
company is free to deal with those assets, therefore creditors’ protection is jeopardized.
Generally when a company fails to discharge its liabilities resulting in the reduction of its share
capital or payment of dividends and other charges out of capital instead of distributable profits,
these circumstances push creditors in precarious position. To protect creditors’ interest our
legislature has imposed a number of limitations and laid down guidelines in regard to the usage
of capital of the companies. In light of these provisions doctrine of maintenance of capital has
been upheld and the liberty to reduce share capital is under proper scrutiny. This paper is an
earnest attempt to find out these provisions in regard to the creditors’ protection.
Provisions regarding maintenance of capital and to deal with its own shares are quite moderate in
US in comparison with India. After 1990 no doubt India witnessed globalization and

Authored by Preetesh Raman Singh, Student of 3rd Year BA LLB(Hons.), National Law University, Jodhpur
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3. liberalization but still most of the prohibitions operate and the rate of these reforms is
significantly low. But comparison with a country likes United States which got independence
three centuries ago and has a complete different market structure is not reasonable. In this decade
Indian companies have started advancing to their full extent but there is more to go. We should
be proud that because of this market and economic policy we were not much affected by the
financial crisis whereas United States’ economy is still trying to recover from its catastrophic
results.
This paper does not promote an unreasonable and unrestricted system for Indian companies to
freely deal with their share capital but advocate a fair regime that meets the demands of the
modern day business transactions. This issue is currently discussed in much awaited Companies
Bill, 2011.
DOCTRINE OF CAPITAL MAINTENANCE
This doctrine was initially developed in the English Company Law and then more or less on the
same lines enacted in the Indian Law. A limited liability company not only has some benefits but
also some restrictions in the form of use of its capital. Liability towards creditor is always
discharged before that of a shareholder. When a company is not able to pay its debts from the
share capital, then it has to rely upon assets. Therefore the assets of the company are treated as
capital for the repayment of creditors. Hence it is necessary that certain amount of capital or
assets have to be maintained so that liabilities towards creditors could be met. Under both
English and Indian company laws there is restriction upon a company to purchase its own share
as it tend to reduce share capital of the company. Only profits have to be distributed among
shareholders. It has also be directed through various judgments that certain capital has to be
maintained and company is not allowed to touch this capital without the prior permission of the
court during its day to day affair. This has given birth to a new fundamental principle of
company law that a particular amount of capital should also be maintained to meet its obligation
towards creditors. And any procedure or transaction even statutory which is likely to reduce this
capital would be contravening to the fundamental principle1.
1
Shareholders interests, protection of creditors, maintainence of capital, c.f. <http://www.law-essays-
uk.com/resources/sample-essays/company/shareholders.php> visited on 22.12.2011
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4. IN LIGHT OF COMMON LAW
In common law this issue has been discussed quite often and has a great relevance with the
company’s administration. There have been conflicting opinions but now the settled law is that a
company cannot reduce its share capital other than lawful means. Moreover this capital should
not be reduced below legal capital. In the Trevor v. Whitworth (1887)2 decision, Lord Watson
laid that 'no legislation can prevent' paid-up capital being 'lost in the ordinary course of the
company's trading'. But it was also held that a limited liability company could not purchase its
own shares as that was equivalent to returning share capital to shareholders ahead of creditors.
However this judgment supports the commercial reality argument, according to which creditors
must accept the risks involved in certain transactions. This judgment was followed by another
highly criticized case of Aveling Barford v. Perion Ltd [1989]3, in this the commercial reality
aspect was ignored and did not look upon the fluctuations in market value of shares. Definition
of distribution was also tried to be interpreted with respect to the raised doubts.
Distribution may cover redemption or repurchase of shares and dividends as well. As per
sections 159(1) and 162(1)4, the method to finance these distributions must be authorized by the
company’s article of association. Section 263(2)(b)5 acts as a watchdog as it only allows such
distribution so far as these do not reduce share capital and should be done only from the profits,
share premium and capital redemption account should not be touched. However section 1356
acts as a proviso to these sections and permits capital reduction on court’s order. Later on these
stringent rules were tried to be relaxed and the promotion of business was emphasized on, so that
it could be beneficial for both creditors and shareholders. In case of any breach or misconduct
creditors do not have any direct recourse but indirect recourse trough a liquidator. This was also
supported in the case of Mills v. Northern Rly of Buenos Ayres (1870)7. But this should be
checked and a direct course of action should be made available for the creditors, this will
2
(1887) 12 App Cas 409
3
[1989] BCLC 626
4
Companies Act, 1985
5
Ibid
6
Ibid
7
(1870) 5 Ch App 621
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5. certainly help in the malfunctioning of the corrupt companies. Section 277(1) of the Companies
Act 1985 provides that distributions received by shareholders in breach of the statutory
provisions are recoverable by the company only if the shareholder knew or ought reasonably to
have known that it was unlawful.
IN LIGHT OF INDIAN LAW
There is not much deviation in Indian law; it also has an ample amount of provisions restricting a
company to deal freely with its share capital. Creditors’ protection has always been a major
problem for the government, since the act was enacted. This Companies Act, 1956 deals
vehemently with the doctrine of capital maintenance. It has been observed that when a company
purchases back its share then it will amount to reduction of capital. To prevent this capital
reduction section 77AA has been enacted which says that when a company purchases its own
shares out of free reserves, then a sum equal to the nominal value of the shares so purchased
shall be transferred to the capital redemption reserve account and details of such transfer shall be
disclosed in the balance sheet8. A limited company is also authorized to issue preference shares
and whenever these shares are redeemed it amounts to reduction of capital, but section 80 of the
act says that the redemption of preference shares should only be made out of the profits of the
company available for the distribution as dividend or from the fresh issue of the capital. If the
preference shares are redeemed from any other source the company must build up a capital
redemption reserve under proviso (d) to section 80(1). This provision is there to support the
fundamental principle that capital of the company must be maintained9.
Further it is very much explicit that if a company fails to make profit but to maintain its goodwill
it decides to distribute dividend, then it will certainly reduce its share capital. Section 205 of the
Companies Act, 1956 lays down prohibition on such distributions as it says that a dividend
(including interim dividend) can be paid out of current profits or profits accumulated of earlier
years. Amount of depreciation also has to be calculated and for this purpose the board meets to
decide how much amount need to be transferred to the reserves as per the act 10. Through this
8
A Ramaiya, “Guide to the Comapanies Act”, Part I, Wadhwa Nagpur, 2006, pg 938
9
Shashi Bala Namitlal v. CIT, (1964) 34 Com Cases 985 (Guj)
10
he Companies (Transfer of Profits to Reserves) Rules, 1975 set out different thresholds/limits for the percentage
of profits to be transferred to reserves depending upon the extent of the dividend proposed to be paid. Under the said
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6. manner capital in the reserve account is always maintained and the company is not allowed to
touch this capital. Hence it helps in the protection of creditors.
But the legislation also provides some provisions which show a departure from the above
stringent guidelines. As per section 100-105 of the Companies Act, 1956 a company is allowed
to reduce its share capital depending upon the special resolution and court’s order.
IN LIGHT OF COMPANIES BILL, 2011
Following Companies Act, 1956 this new bill also takes the issue of creditors’ protection with a
great concern. Clause 55 of the bill which is corresponding to section 80 and 80A of the act
clearly lays down that the amount which is spent on the redemption of preference share, an
equivalent amount must be transferred to the capital redemption reserve account. Similarly
clause 69 which is corresponding to section 77AA of the act provides that in case of buy-back of
shares out of free reserves, a sum equal to the nominal value of the shares so purchased shall be
transferred to capital redemption reserve account. Under clause 66 of the bill similar procedures
for the reduction of capital on the lines of sections 100-105 of the act have been mentioned.
Clause 67 and 68 deal with the buy-back of shares and also talk about its prohibition as well as
exceptions. Similarly clause 123 of the bill which corresponds to section 205 of the act clearly
says that the dividend of a company shall be declared out its profits not from any of the reserves
other than free reserves. However, before the declaration of any dividend certain percentage of
profit may be transferred to the reserves of the company. Therefore it can easily be inferred that
regarding creditors’ protection there have not been many changes made. It is quite explicit that
our legislature has completely ignored the modern day business requirements and did not take
the demands of companies in consideration11.
CONCLUSION
Whether it is English law or Indian law, creditors’ protection has always been a highlighted
issue. No doubt United States has followed a liberal regime but it has altogether a different
model of economy from India. India has mixed economy rather than capitalist economy.
Rules, if the proposed dividend exceeds 20% of the paid-up capital, the amount to be transferred to reserves should
be at least 10% of the current profits.
11
C.f. <http://www.mca.gov.in/Ministry/pdf/The_Companies_Bill_2011.pdf> visited on 22.12.2011
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7. Functioning of Indian market is quite different from United States but somewhat similar to
common law countries. In 1956 it’s been only 17 years since India got independence; her market
was struggling to stand. At that time it was really a gamble for the creditors to lend their money
to premature companies. Hence it became essential for the legislature to come up with legislation
favourable to creditors and directs companies to maintain their share capital so that their
obligation towards creditors can be easily discharged without any problem.
But today after 20 years since India faced globalisation and liberalisation, companies have
become mature and well established as they have increased their business affairs. These stringent
regulations are proving to be obstacles in the path of the development of these companies. Profit
making has become the sole motive of these companies and for that they require freedom to deal
with their capital without any restriction. They need extra capital to make more profit but they
are bound by the law. Even the Companies Bill, 2011 has also been drafted on the same lines of
the act and the modern days requirements have been neglected. This is the high time for the
legislature to think upon this issue and to draft such a bill which can create a bridge between the
restriction and freedom.
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