Capital Maintenance Rule: An Introduction

More often than not companies face a situation where the shareholders sell their shares back to the company, which leads to a moderate to stark reduction in the assets of the company and hence, the company is left with comparatively less assets in hand to repay the amount borrowed from creditors. Thus, the maintenance of capital seems like the last resort to protect the creditors. It gives the creditors an additional sense of security and it also ensures that the assets of the company are not just simply dissipated to shareholders.

This doctrine is created to ensure the availability of sufficient capital at all times in the business in order to clear dues and also to provide security to the stakeholders for the money invested by them. This doctrine is the protective shield for the creditors, which actively protects the interests of the banks and other numerous financial institutions, which lend their money to the company.

Chapter 1- Case Law and Reasons to reduce the share capital

National Company Law Tribunal passed an order from which the scope of section 66 of the Companies Act, 2013, may be understood; the order stated that selectively reducing equity share capital available for non-promoter shareholders and returning of excess capital is not covered within the ambit on Section 66 as it is the arrangement between the shareholders and the company, but may be covered under Section 230-232 of the Companies Act, 2013, wherein any arrangement between these parties is permissible. This order was passed in the case of Brillio Technologies Pvt. Ltd vs Registrar Of Companies[1] and as the appellant was aggrieved, it appealed in National Company Law Appellate Tribunal.

The NCLAT, New Delhi, while giving its judgment held that “Consent affidavits from the creditors is mandatory for reduction of share capital, SPA cannot be utilized for making payment to non- promoter shareholders, selective capital reduction is allowed if the non-promoter shareholders are paid fair and true value of their respective shares and that section 66 of that Act makes such a provision for reduction without it coming under any arrangement or compromise.” Therefore, the court allowed the plea and set aside the above-mentioned order by the Tribunal.

Reasons to reduce the share capital

Why would a company reduce its own share capital, considering the importance of assets/cash in the functioning of the company?

Even though share capital is a significant criteria and government requires companies to maintain a minimum amount of share capital, companies still reduce their share capital for altering the financial structure and it is done to achieve the following objectives-

1. Disruption in the balance sheet owing to the accumulated losses being expensed by the share capital on assets side.

2. A possibility of several shareholders relinquishing their interest in the company, for which their capital needs to get cancelled.

3. In case a company has surplus funds, it refunds surplus funds by reducing the share capital- by way of reducing share price of cancellation of shares.[2]

A company reduces its share capital by complying with the provisions laid down in Section 66 of Companies Act, 2013.

Chapter 2- Important Statutes

Section 66– Reduction of capital

Section 66 governs the reduction of capital in a company.  Generally, the companies, in order to decrease their capital, have to seek the consent of the National Company Law Tribunal.

Section 66(1) mentions three modes in particular-

  1. By way of reducing the liability of members for unpaid capital,
  2. By way of writing off lost or unwanted capital; the company sets off accumulated losses against its capital, however, the share capital gets reduced,
  3. By way of refunding a small part of the paid up capital, which is in excess of the wants of a company.[3]

According to section 66 of the Companies Act, the company can only do it upon passing off a special resolution.  Clause 2 of section 66 the tribunal shall give notice of every application made of capital reduction to the Central Government, Registrar, SEBI, and the creditors of the company. The tribunal is directed to take into consideration, representation made by them, if any, within the period of three months from the date of the receipt of the notice.

Objective of requiring this sanction is three folds- in order to protect the interests of creditors, shareholders, and the public.

Creditors are entitled to make objections to this application if they feel the reduction of share capital involves-

  • Reduction of liability with respect to uncalled capital
  • Payment to any shareholder of any paid up capital, and
  •  In any other case if the tribunal so directs that interests of the creditors are jeopardized.[4]

  Where tribunal is satisfied that the interests of the creditors have been secured, it may confirm the reduction, on such terms and conditions as it may deem fit. Company shall deliver to the ROC (Registrar of Companies) a certified approved copy of the tribunal order, showing the details for registration within 30 days of the receipt of the order. The registrar will register the order and the resolution for reducing the capital will then take effect. Notice of the registration shall be published in such a manner as may be directed by the tribunal.

Section 68– Power of company to purchase its own securities

Section 68 of the companies act governs the buy-back of shares by the company as it harms the security of the creditors. [5]According to the section the companies are allowed to buy-back less than or equal to 10% of its total paid up equity capital and free reserves. Such a transaction is authorized by the Board of Directors of the company at their meeting.

However, according to clause 2 of this section companies are also allowed to buy back less than or equal to 25% of its own shares (fully paid up) from the shareholders only if the articles of the company authorize the purchase. And again, a special resolution has to be passed at the general meeting of the company by which the purchase of shares by the company is allowed.  Moreover, one more condition for the company to be cautious of is that the ratio of secured and unsecured debts levied on the company after such transaction is less than twice the paid up capital.

The point to be noted here is that sanction of NCLT is not required under section 68. This is because this transaction is authorized by the Article of Association as well as the shareholders of the company at the general meeting. Moreover, the interests of the creditors are already being taken care of under section 68 of the companies act by ensuring the debt-equity ratio is not too high.

Furthermore, clause 6 of the said section states that a Declaration of Solvency has to be filed with the SEBI and the ROC, stating that the company will not be declared insolvent within 365 days of Directors authorizing the return of assets to the shareholders. This is necessary because law is aware of opportunistic behavior of the shareholders.

Section 242– Powers of the tribunal

There might be situations when a member of a company might be suspicious of ill-practices happening in the company. The business-affairs might harm the public interest.

[6]Section 241 (1) Any member of a company who complains that—(b) the material change, not being a change brought about by, or in the interests of, any creditors, including debenture holders or any class of shareholders of the company, has taken place in the management or control of the company, whether by an alteration in the Board of Directors, or manager, or in any other manner whatsoever, and the by reason of such change, it is likely that the affairs of the company will be conducted in a manner prejudicial to its interests or its members or any class of members, may apply to the Tribunal, provided such member has a right to apply under section 244, for an order. 

Clauses (c) and (d) of sub-section (2) of section 242 deal with reduction of share capital.  If a complaint of the nature discussed in section 241 is brought to the tribunal, then an order, passed under chapter 16 of companies act, provide for reduction of share capital of the company in effect of mal-practices within the company, and restrictions of transfer of shares to shareholders and depleting the assets of the company.

Failure of compliance with the doctrine of capital maintenance is a punishable offence. If a company or a member of a company fails to follow section 68 of companies act, they shall be liable with fine of ₹1,00,000.

Chapter 3- Capital Maintenance and the Reduction of Financial Agency Costs

An obvious potential problem for creditors is the so-called “liquidating dividend”. This involves shareholders procuring the firm to liquidate assets and to transfer the proceeds to themselves. Such a transfer reduces the pool of assets available to satisfy creditors’ claims. We would expect rational creditors to anticipate such behaviour by shareholders, and incorporate the expected costs into the price of a loan. However, the risk-adjusted interest rate rapidly becomes prohibitively high unless some sort of restriction on the gratuitous transfer of assets to shareholders is imposed. Distribution restrictions can serve this function.

Another problem is referred to as “underinvestment”. This refers to shareholders’ reduced incentive to commit money to good investment projects when the firm has debt outstanding. An investment opportunity will be worth taking if it has a positive “net present value”. In short, this means that on the basis of available information we would expect its costs to be less than its revenues, once all the values have been “discounted” to reflect the fact that the payments will be made in the future and the value of money reduces with time. Where the firm has debt outstanding, then increases in firm value will also increase the face value of the debt by lowering the probability of default. In short, the gains from the investment will be shared between the firm’s debt and equity holders. If the project has to be financed from a fresh issue of shares or cash already held by the firm, then the effective return to shareholders may be unattractively low, in which case the investment will not be made.[7]

Chapter 4- Limitations of the doctrine

Creditors are unlikely to consider that the size of a company’s share capital is a relevant factor in assessing the risk of default when lending to a particular firm. If this is so, then the implication is that the capital maintenance doctrines embodied in the Companies Act serve no useful purpose. To the extent that compliance with the law imposes costs on parties, the rules generate a net social loss. In other words, they prove to be inefficient.

Why might creditors not be concerned with share capital? Firstly, the share capital entries in a company’s memorandum and accounts convey very little information to creditors. The concept of share capital is essentially historic. It is based on the price paid to the company for shares issued at some previous time. This money may no longer be represented by corporate assets. Indeed, where shares in private companies are issued for non-cash consideration, it is possible that the value of the assets transferred to the company was never as much as the share capital. Nor need the size of the share capital bear any resemblance to the success or otherwise of the company’s business. To put the point another way, the theoretical models tend to assume only one creditor who contracts with a firm on start-up. Whilst restrictions on distributions may assist such a creditor, the terms of the original restriction are unlikely to be appropriate for the nth creditor who lends to a firm several years after start-up.

Secondly, if subsequent creditors want to have restrictions on distributions, then they are free to bargain for them by contract. Such contractually-agreed upon provisions are indeed commonly observed, and far more likely to be tailored to the needs of creditors than statutorily-imposed ones. [8]

            It is also possible that rules requiring companies to carry a minimum capital may assist in correcting an externality resulting from limited shareholder liability. Externalities are costs which economic actors impose on others in such a way that those costs are not mediated by market processes. For example, a driver who speeds is not required to pay other road users in advance for the increased risks of harm which he or she imposes upon them by their activity. Some areas of law, for example tort or environmental regulation, can be viewed as systems which impose “prices” on activities that are socially harmful so as to encourage actors to internalise their social costs. In the corporate context, limited liability may result in corporate shareholders being able to avoid liability for torts and environmental damage committed by their company, and hence undermine the law’s ability to correct these externalities.

It is theoretically conceivable that rules mandating a minimum share capital can be seen as a response to this problem. By ensuring that firms have at least a certain minimum level of assets available to satisfy creditors, shareholders are prevented from undercapitalising firms and the law’s ability to correct externalities is enhanced. However, a universal minimum capital requirement is unlikely to be efficient. It will tend to offer inadequate protection in high-risk industries, whilst creating an unnecessary barrier to entry in low-risk industries. This suggests that a minimum capital requirement for public companies, as set out in the Second Company Law Directive, is likely to be inefficient in its operation. 

Conclusion

Capital is an important requirement in a business. It ensures smooth functioning of the company since no company can operate without a sufficient reserve of funds. Since a company borrows funds from financial institutions, it is their responsibility to pay them back. Hence, a limited company must be restricted from purchasing its own shares and deplete its assets to shareholders. The national legislation was brought into the word of company law in order to protect the stakeholders- creditors and shareholders. Although we computed a few limitations of this doctrine however, the dis-advantages could not match up with the advantages of the rule. Moreover, maintenance of the capital in the firm makes the creditors feel secure as it reduces the risk of default and therefore, this is the legal phenomenon behind ‘secured creditors’.


[1]  Brillio Technologies Pvt. Ltd vs Registrar Of Companies, 2021.

[2] Ketan Dalal. “Capital Reduction – Regulatory & Tax Issues: Part 1 | Lawstreetindia.Com.” Lawstreetindia, 1 Aug. 2019, http://www.lawstreetindia.com/experts/column?sid=314.

[3] Note- No reduction shall be made if the company is in arrears in repayment of any deposits/interests thereon. 

[4] But only such creditors are entitled to object to whom the company owes a debt and which would have been provable in the winding up (Preferential creditors)

[5] Companies Act 2013

[6] Companies Act 2013

[7] Shwayder, Keith. “The Capital Maintenance Rule and the Net Asset Valuation Rule.” The Accounting Review, vol. 44, no. 2, American Accounting Association, 1969, pp. 304–16, http://www.jstor.org/stable/243806

[8] Revsine, Lawrence. “A Capital Maintenance Approach to Income Measurement.” The Accounting Review, vol. 56, no. 2, American Accounting Association, 1981, pp. 383–89, http://www.jstor.org/stable/245820

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