Volume IV (2013) ISSN 2218-2578

The Northern University Journal of Law

The Doctrine of Capital Maintenance and its

Statutory Developments: An Analysis
Md. Saidul Islam*

Abstract
This article emphasizes on the implication of the doctrine of capital maintenance
which means the capital of a company needs to be kept intact for there is a
contribution of the creditors and retaining the capital is normally expected to
guarantee repayment to the creditors. Any reduction of capital can diminish the
liability of members and consequently the position of the creditors can be vulnerable.
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 well as satisfy the needs of the modern business.

Methodology
Analytical method of research has been followed for this study.

1. Introduction
The doctrine of capital maintenance - i.e. that a company must obtain proper
consideration for shares that it issues and that having received such capital it must not
repay it to members except in certain circumstances - is a fundamental principle of
company law.1 In fact, the doctrine emphasizes on a fundamental duty of the
companies to keep the capital intact for the safety of the creditors giving the mandate
to the courts to supervise whether the capital is dissipated lawfully or not.

The doctrine of maintenance of capital underpins the legal rules in the following
important areas2: payment of dividends or other distributions to shareholders;
reduction of a companys share capital and/or reserves; prohibition on the provision
by a company of financial assistance for the purchase of its own shares; and a
companys redemption or purchase of its own shares.

2. Basics of the Doctrine of Capital Maintenance

Due to the limited liability of shareholders, protection of creditors has always been a
concern. To that end there developed the doctrine of capital maintenance which
essentially is a collection of rules designed to ensure, firstly, that a company obtains

* Assistant Professor, Department of Law, Eastern University

1
Please visit http://www.nortonrosefulbright.com/knowledge/publications/17080/capital-maintenance-
the-companies-act-2006 accessed on 08/12/13.
2
Please visit http://www.nortonrosefulbright.com/knowledge/publications/17080/capital-maintenance-
the-companies-act-2006 accessed on 08/12/13.
47
 The Doctrine of Capital Maintenance and its Statutory Developments: An Analysis

the capital which it has purported to raise, and secondly, that the capital is
maintained, subject to the exigencies of the business, for the benefit and protection of
the creditors of the company. Thus, the objective of the doctrine of capital
maintenance is to prevent fraudulence and to the creditors in companies by reducing
share capital and to ensure liabilities of shareholders. Therefore, an attempt must be
made to compromise the interest of creditors in the complete satisfaction of their
claims and the interest of corporations in managerial freedom.

It is a fundamental principle of company law that the share capital must be

maintained. It has been said that a company cannot, without the leave of the court or
the adoption of a special procedure, return its capital to its shareholders. It follows
that a transaction which amounts to an unauthorized return of capital is ultra vires
and cannot be validated by shareholder ratification or approval.3

The principle that the share capital of a company must be maintained boils down to
the rules that paid up share capital must not be returned to its members and their
liability in respect of capital not paid up on shares must not be reduced. 4

The doctrine has the following general consequences 5 subject to exceptions approved
by the national legislations: 1) a company generally cannot purchase its own shares
unless it follows the strict procedures laid down by the Act; 2) a subsidiary company
generally must not be a member of its holding company; 3) it is generally unlawful
for a company to give any kind of financial assistance for the acquisition by any
person of its own shares or those of its holding company; 4) dividends must not be
paid to the shareholders except out of the distributable profits; 5) where a public
company suffers a serious loss of capital, a meeting of the company can be called to
discuss the issue.

There are certain exceptions to the principle: i) if the law permits, a company may
reduce its share capital with the consent of the court; ii) a company may redeem its
shares if the Act concerned allows it; iii) a company may purchase its own shares
under a procedure prescribed by the law; iv) capital may be returned to the members,
after the debts of the company have been paid in a winding up.6

Capital maintenance, in another view, is stating that a profit should not be recognized
unless a business has at least maintained the amount of its net assets (i.e., capital)

3
Hoffman J. in Aveling Barford Ltd. V. Perion Ltd. (1989) 1 W. L. R. 360 at p. 364.
4
Geoffrey Morse, Charlesworth and Morse: Company Law, Fourteenth Edition, 1991, ELBS, p. 190.
5
Ibid, pp. 190-191.
6
Ibid.
48
Md. Saidul Islam

during an accounting period. Stated differently, this means that profit is essentially
the increase in net assets during a period.7

Capital maintenance, in accounting, involves two sub-concepts8 : the financial and

the physical capital. The financial capital maintenance concept is that the capital of
a company is only maintained if the financial or monetary amount of its net assets at
the end of a financial period is equal to or exceeds the financial or monetary amount
of its net assets at the beginning of the period, excluding any distributions to, or
contributions from, the owners. On the other hand, the physical capital maintenance
concept is that the physical capital is only maintained if the physical productive or
operating capacity, or the funds or resources required to achieve this capacity, is
equal to or exceeds the physical productive capacity at the beginning of the period,
after excluding any distributions to, or contributions from, owners during the
financial period. However, this article only involves the study on the financial capital
maintenance

3. Origin and Rationale of the Doctrine of Capital Maintenance

The reasons for the origin of the doctrine can be twofold; firstly to protect the interest
of the creditors, and secondly to ensure the lawful dissipation of the assets of the
company. The courts have always been anxious to keep the capital of the company
intact9 for the creditor gives credit to that capital; gives credit to the company on the
faith of the representation that the capital shall be applied only for the purpose of the
business and, therefore, has a right to say that the corporation shall keep its capital
and not return it to its shareholders.10

However, it is worth mentioning that the doctrine has been developed through a
series of judicial interpretation in company law cases in England. Jessel M. R., in
Flitcrofts Case11, indirectly stated about two aspects of the doctrine of capital
maintenance- i) the creditors have a right to see that the capital is not dissipated
unlawfully; and ii) the members must not have the capital returned to them
surreptitiously. These two aspects are governed by the rules of a) capital reduction
and b) company distributions.
In Trevor v Whitworth,12 a company bought back almost a quarter of its own shares.
During liquidation of the company, one shareholder applied to court for the balance

7
Available on http://www.accountingtools.com/ questions-and-answers/ what- is- capital maintenance.
html, accessed on 08/12/13.
8
Available on http://www.oxfordreference.com/view/10.1093/oi/authority.20110803095547696, see
also http://www.wisegeek.com/what-is-capital-maintenance.htm, accessed on 08/12/13.
9
Dr. M. Zahir, Company and Securities Laws, First published in 2000, the University Press Limited,
Dhaka, p. 50.
10
Jessel M. R. in Flitcrofts Case (1882) 21 Ch. D. 519.
11
Ibid; (1882) 21 Ch. D. 519.
12
(1887) 12 App. Cas. 409.
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 The Doctrine of Capital Maintenance and its Statutory Developments: An Analysis

of amounts owed to him after the buyback. The Court of Appeal held that he should
be paid. The House of Lords held the buyback was ultra vires the company declaring
that the company could not purchase its own shares, even though there was a
provision to that effect in the memorandum of association since this would result in a
reduction of capital. It is also held that there can be no return of capital to the
members other than on a proper reduction of capital duly sanctioned by the court.
In Aveling Barford Ltd. V. Perion Ltd.,13 it is held that on a winding up of company,
shareholders can retrieve their capital only if all the creditors have been paid.

The principle was authoritatively stated by the House of Lords in Trevor v

Whitworth, and has been subsequently applied both by the courts and in statutory
provisions. The objective of the rule has always been thought to be the protection of
creditors, who are entitled to assume that the risk of a loss of the companys capital is
confined to ordinary commercial activity. The rule is firmly entrenched in both
English and Indian law, although its scope varies considerably.

These case laws have been the foundations of the doctrine of capital maintenance.
But the position of the UK has been modified into a relaxed one due to the necessities
of the modern business demands in various facets. In the UK, the rule governing the
doctrine of capital maintenance was reformed in 1980 and replaced with a statutory
procedure so that shares can either be classed as redeemable or be bought back, under
the Companies Act 2006 sections 684-723. In Australia, share buybacks are allowed
under sections 257A-257J of the Corporations Act 2001. The doctrine remains to be
the foundation stone of the company laws in countries. But, modern business needs
have persuaded the countries to relax some of the aspects of the doctrine.

4. Contemporary Statutory Laws Governing the Doctrine of Capital

Maintenance
This section of the study shows how the doctrine of capital maintenance is being
governed in countries having the similar features and approaches of laws of
companies especially on capital management.

4.1 In Bangladesh
The traditional restrictive approach has been taken in respect of governing the rules
of capital maintenance in the Companies Act, 1994 in Bangladesh.

a. Reduction of Capital
No company limited by shares shall have power to buy its own shares or the shares of
a public company of which it is a subsidiary company, unless the consequent

13
(1989) BCLC 626 at p. 630-3.
50
Md. Saidul Islam

reduction of capital is effected and sanctioned in the manner provided by sections 59

to 70.14

Where the proposed reduction of share capital involves either diminution of liability
in respect of unpaid share capital or the payment to any shareholder of any paid-up
share capital, every creditor shall be entitled to bring objection to the court against
that reduction.15 The Court if satisfied with respect to every creditor of the company
who under this Act is entitled to object to the reduction, that either consent to the
reduction has been obtained or his debt or claim has been discharged or has been
determined or has been secured may make an order confirming the reduction on such
terms and conditions as it thinks fit. 16

b. Financial Assistance
No company limited by shares other than private company or a subsidiary company
of a public company, shall give whether directly or indirectly, and whether by means
of a loan guarantee the provision of security or otherwise any financial assistance for
the purpose of or in connection with a purchase made or to be made by any person of
any shares in the company: Provided that nothing in this section shall, where the
lending of money is part of the ordinary business of a company, be taken to prohibit
the lending of money by the company in the ordinary course of its business.17

c. Dividends
No dividend shall be paid otherwise than out of profits of the year or any other
undistributed profits.18

d. Purchase of own share

A company limited by shares is not generally entitled to buy its own shares unless
they follow the proper procedure of it prescribed under the provisions of the
Companies Act, 1994. However, a company can buy its own shares out of its profit
capital as per the Companies Act, 1994.

4.2 In England19
In England, the Companies Act 2006, hereinafter called as CA 2006, makes a number
of important changes to the rules relating to capital maintenance and, in line with the
deregulatory objectives of the Act, a number of the statutory requirements in this
regard have been relaxed. This briefing discusses some of the key areas of law which

14
Section 58 (1) of the Companies Act, 1994.
15
Section 62 of the Companies Act, 1994.
16
Section 64 of the Companies Act, 1994.
17
Section 58 (2) of the Companies Act, 1994.
18
Article 98, Schedule-I of the Companies Act, 1994.
19
Please visit http://www.nortonrosefulbright.com/knowledge/publications/17080/capital-
maintenance-the-companies-act-2006 accessed on 08/12/13.
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 The Doctrine of Capital Maintenance and its Statutory Developments: An Analysis

have developed in relation to capital maintenance and explains the recent

deregulatory measures which have been introduced.

The general principles governing the doctrine of capital maintenance were originally
developed by the courts and since then have been increasingly superseded by statute,
most notably Part V of the Companies Act 1985 (hereinafter mentioned as CA 1985)
and, from the applicable dates of implementation, Parts 17, 18 and 23 of the
Companies Act 2006. In particular, with effect from 1 October 2008, the rules on
unlawful financial assistance will no longer apply to private companies (in most
circumstances) and private companies will also be allowed to reduce their share
capital without the need to go to court.

a. Distributions
The provisions relating to distributions in the CA 1985 have broadly been restated in
Part 23 CA 2006 which came into force on 6 April 2008 and applies to distributions
made on or after that date. It continues to be the case that a dividend or distribution to
members cannot be made except out of profits available for the purpose by reference
to relevant accounts and Part 23 sets out the rules relating to permissible
distributions.

b. Reduction of Share Capital

From 1 October 2008, the CA 2006 introduces a new procedure for private
companies to be able to reduce their share capital by a special resolution supported
by a solvency statement given by all the directors. This new procedure does not
require court approval of the reduction and introduces ability for the private company
concerned to reduce its capital in any way which was previously only possible if the
company was an unlimited company.

It will not be permissible to qualify a solvency statement in any way and directors
will commit a criminal offence if they make a solvency statement without having
reasonable grounds for the opinions expressed in it. The nature and extent of the
work which will have to be done to ensure that directors have reasonable grounds for
giving a solvency statement will depend on the circumstances.

In relation to reductions of capital confirmed by the court, the CA 2006 broadly

restates the procedure contained in the CA 1985, subject to certain minor
amendments which come into effect on 1 October 2009. The court-approved route is
available to both public and private companies, unlike the new out of court procedure
referred to above which only applies to private companies.

c. Financial Assistance
The prohibition on the giving of financial assistance by private companies in most
circumstances will be repealed with effect from 1 October 2008. As a result of this

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Md. Saidul Islam

repeal, from 1 October 2008, there will no longer be any statutory whitewash
procedure. However, the prohibition on the giving of financial assistance by public
companies contained in the CA 1985 will be retained until 1 October 2009, when it
will be replaced by similar provisions in Chapter 2 of Part 18 CA 2006. In addition, a
private company will continue to be unable to give financial assistance for the
acquisition of shares in its (direct or indirect) public holding company.

Notwithstanding the repeal of the statutory rules, a transaction which might once
have constituted unlawful financial assistance still needs to be considered in the light
of the following general company law principles which must continue to be taken
into account: the transaction must be in the best interests of the company (likely to
promote the success of the company for the benefit of its members in accordance
with section 172 of the CA 2006); and the transaction must not breach the rules on
distributions or otherwise constitute an illegal reduction in the capital of the
company.

d. Purchase of Own Shares

The general rule is that a limited company may not acquire its own shares by
purchase, subscription or otherwise, except as permitted. Part 18 CA 2006, which
comes into effect on 1 October 2009, brings together the current methods by which a
limited company can acquire its own shares and section 658 CA 2006 prohibits the
acquisition by a limited company of its own shares except in accordance with the
provisions of that Part. One advantage of a company reducing its share capital by
purchasing its own shares is that the purchase price for the shares concerned may
exceed the amount of capital that those shares represent.

The key changes to the capital maintenance rules introduced by the CA 2006, being
the repeal of the statutory prohibition on the giving of financial assistance by private
companies and the new out of court reduction of capital procedure for private
companies, are to be welcomed. Whilst it will be interesting to see how market
practice develops in relation to the new out of court reduction procedure available to
private companies, the changes should simplify many transactions, shorten
transaction timetables and reduce costs.

4.3 In Singapore20
The Companies (Amendment) Act 2005 has reformed the law of Singapore on
capital maintenance substantially. It has, inter alia, enabled a company that satisfies
the requisite solvency tests to reduce capital, engage in financial assistance and
share buyback. It is argued that whilst the reforms have reduced compliance costs,
the failure to bring the solvency-based reforms to their logical conclusion has made
Singapore laws on capital maintenance incoherent.

20
Wee Meng Seng, Reforming Capital Maintenance Law: The Companies (Amendment) Act 2005,
Singapore Academy of Law, (2007) 19 SAcLJ Part II (September), Summary.
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 The Doctrine of Capital Maintenance and its Statutory Developments: An Analysis

4.4 In India
The Indian Companies Act, 1956, hereinafter mentioned as the Act, contains an
ample number of provisions restricting a company to deal freely with the capital of it.
The Act deals vehemently with the doctrine of capital maintenance. It has been
observed that when a company purchases back its shares 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 sheet.21

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 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) of the Act. This
provision is there to support the fundamental principle that the capital of the company
must be maintained.22

Further it is very much explicit that if a company fails to make profit but to maintain
goodwill decides to distribute dividend, it will certainly reduce its share capital.
Section 205 of the Act lays down the prohibition on such distribution 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.23 Through this 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 the creditors.

But the Act also provides some provisions which show a departure from the above
stringent guidelines. As per the sections 100-105 of the Act a company is allowed to
reduce its share capital depending upon the special resolution and the courts order.

4.5 In the United States24

In the United States there is no general rule prohibiting limited companies from
buying shelf owned shares. An American company wishing to provide its employees
with shares as part of a bonus plan or a profit sharing scheme, or to acquire other

21
A Ramaiya, Guide to the Companies Act, Part-I, Wadhwa Nagpur, 2006, p 938.
22
Shashi Bala v. CIT, (1964) 34 Com Cases 985 (Guj).
23
The Companies (Transfer of Profits to Reserves) Rules, 1975.
24
http://www.takeovers.gov.au/content/Resources/other_resources/downloads/jenkins_committee.pdf,
accessed on 12/12/13.
54
Md. Saidul Islam

companies, will often accumulate a sufficient number of its own shares by purchase
in preference to issuing new shares and thereby unnecessarily increasing its issued
share capital. As companies in the United States are generally free to reduce their
share capital without the consent of the Court, this power for a company to buy its
own shares also makes it possible to effect a selective reduction of capital, the shares
of those members who wish to sell them being bought by the company and then
cancelled: members of small companies wishing to retire are often bought out in this
way.

5. Conclusion
A limited company should be expressly prohibited from reducing its capital and from
purchasing its own shares save as provided in the national legislation and the
procedure for the reduction of capital must be designed to protect both creditors and
shareholders. It might be suggested, however, that it is not always possible for the
Court to protect the interests of a section of shareholders or a creditors unfairly
prejudiced by a reduction of capital and that provision might be made whereby the
court could obtain an independent assessment of the justice of a reduction scheme.

It has been suggested that in some circumstances, for example, where the reduction
consists simply of cancelling paid up share capital which is lost or is represented only
by such intangible assets as goodwill, it should not be necessary to obtain the consent
of the Court. It will lessen the unnecessary hardship in the procedure.

To sum up, we can say that the national legislation must be designed to ensure that a
company with a share capital raises it and subsequently makes no return to its
shareholders unless net assets are retained which equal or exceed the value of that
capital.

55