Capital requirements are the funds that a company needs to function, develop its business, and achieve its strategic objectives. They vary with the nature, size, and stage of business development, industry practices, and regulatory demands. Capital can be required for several reasons, including the purchase of fixed assets, the provision of working capital, research and development outlays, and expansion into new markets. Fundamentally, capital is the lifeblood of a company, serving to provide the means of finance in an effort to fulfill short-term commitments as well as long-term ambitions. Firms can choose to finance their capital needs from any of the various sources of finance, including equity finance, borrowing finance, internally generated funds, or a combination thereof. For regulated industries like banking and insurance, compliance with required capital adequacy is important not only for capital planning but also for legal compliance in order to become solvent and safeguard stakeholders. Precise measurement and capital planning requirements are required to avoid undercapitalisation, which will smother growth and put a firm at risk for loss of money, or overcapitalisation, which can lead to inefficiencies. Hence, the capital needs for financial administration and long-term survival of a venture should be understood.
What is a Company Under the Companies Act 2013?
The Companies Act, 2013 defines a company as an incorporated and registered juristic person in accordance with the provisions of the Act. ‘Company’ is defined in Section 2(20) as a firm which is registered and established under this Act or any previous company law. It is a distinct legal person apart from the directors and shareholders, and it can own property, enter into contracts, and sue or be sued in its name. A company has perpetual succession, so modifications in ownership or management do not cause it to cease to be. Shareholders can alter and directors can resign or pass away, but the company continues to be dissolved officially. This company provides its members limited liability, i.e., their own assets are protected from the company’s liability to the level of their investment.
The Companies Act, 2013 specifies four categories of companies, namely private companies, public companies, one person companies, and Section 8 companies (not for profit), each with its own features and compliance standards. The Act covers all aspects of the functioning of a company, right from incorporation to management, disclosure, governance, and winding up.
In short, a company in the Companies Act of 2013 is a formal and regulated corporate body that provides flexibility, security, and accountability in its professional and business undertakings.
What is Reserve Capital?
According to the Companies Act of 2013, reserve capital forms a portion of a company’s uncalled share capital which has been decided, through a special resolution, will not be called unless the company is liquidated. It is also referred to as ‘reserved responsibility.’ This type of capital serves as a financial protection for creditors, allowing extra funds to be drawn from shareholders in case of the dissolution of the firm to pay off dues.
As per Section 65 of the Companies Act of 2013, only a company with share capital is allowed to create reserve capital, and it needs to be approved by a special resolution. It cannot be called upon in the day-to-day functioning of the company. Reserve capital increases the creditworthiness of a company and gives assurance to the creditors that certain funds will be available on liquidation. It does not appear separately on the balance sheet as it is held uncalled until the winding up of the company.
Section 65 Of The Companies Act, 2013
Section 65 of the Act states:
“A company limited by shares may, by special resolution, determine that any portion of its uncalled share capital shall not be called except in the event of the company being wound up; and thereupon such portion shall not be capable of being called except in that event.”
Section 65 of the Companies Act, 2013 deals with reserve capital, or ‘reserved liability.’ This section applies only to share-limited companies and gives a statutory framework to a company to reserve a portion of its uncalled share capital for use in case of liquidation. This enables a company to treat a part of its uncalled share
capital as reserve capital by passing a special resolution by at least 75% of its members. This reserved amount is not for use in normal business operations, like financing expansion or paying current obligations, and can only be invoked during the process of winding up, which is when the company is formally dissolved and its assets are liquidated to pay off creditor claims.
Conditions and Limitations
- Reserve capital can only be created by companies limited by shares under this section.
- A special resolution is required to enable the formation of reserve capital, which is applicable only on uncalled share capital and not on amounts already called or paid.
- The set-aside reserve capital, once formed, cannot be revoked or used for normal business purposes.
The reserve capital is not shown separately on the balance sheet. It is still included in the uncalled capital under the authorised share capital and only matters during the process of liquidation. It is also not treated as an accounting reserve (as opposed to a general or capital reserve), but as a limitation on a segment of the uncalled share capital.
Section 65 of the Companies Act of 2013 provides that companies may strengthen their financial structure and creditworthiness by setting apart some uncalled share capital as reserve capital. Although seldom employed in day to day business operations, it plays a significant function in bankruptcy scenarios by ensuring the company has further funds to repay its obligations on winding up.
Case Illustration
To better understand Section 65, let us take ABC Ltd., which is a company limited by shares with an authorised share capital of Rs. 10 crores and 10 lakh equity shares of Rs. 100 each. The company has called up Rs. 70 per share and left Rs. 30 per share uncalled.
ABC Ltd. is now conscious of possible financial risks and wants to protect its creditors’ interests in case of liquidation. Therefore, the company takes a special resolution under Section 65, providing that Rs. 10 of the uncalled Rs. 30 per share will be called only in case of winding up. This reserve capital is Rs. 10 per share, aggregating to Rs. 1 crore (10 lakh shares x Rs. 10).
If ABC Ltd. is liquidated because of insolvency, the liquidator can ask shareholders to pay the reserve capital to repay debts. This amount cannot be asked for during regular business hours. This approach provides an added financial guarantee to creditors and improves the creditworthiness of the company, particularly in cases of insolvency.
Purpose And Significance Of Section 65
Section 65 of the Companies Act of 2013 is important in corporate finance and compliance by providing for the concept of reserve capital, also known as reserved liability. Under this provision, corporations limited by shares are permitted to set aside a part of their uncalled share capital, only such part as is available in case of liquidation. The major objective of this rule is to protect the interests of stakeholders and creditors, particularly in cases of corporate insolvency.
Purpose of Section 65
- Safety of creditors’ interests by providing additional security; in the scenario of liquidation, when a company’s assets prove to be inferior to its debts, reserve capital serves as a secondary source of funding.
- Encouraging financial prudence by allocating part of uncalled capital as reserve capital, assisting organisations in circumventing risky capital calls and enjoying a buffer, thus promoting conservative financial planning and long-term financial stability.
- Ensuring legal clarity and a structured process, since Section 65 statutorily legalises reserve capital by way of a special resolution, making things transparent and certain in relation to this component of uncalled capital.
Significance of Section 65
Section 65 is essential for business insolvency planning and creditor protection because it allows companies to set aside a portion of their uncalled capital for winding up purposes, thus striking a balance between shareholders’ and creditors’ interests. Even less commonly used for day-to-day business operations, this provision proves to be most useful in maintaining financial solvency in case of liquidation and adds further strength and purity to India’s corporate governance process.
- Improves Creditworthiness: Having reserve cash can enhance the creditworthiness of a company by reflecting financial stability to creditors and investors when the company goes into liquidation.
- Averts Capital Misappropriation: Reserve funds can be accessed only after liquidation, which inhibits management from using them for normal or non-critical expenditures, thus ensuring fiscal discipline.
- Maintains Equality Amongst Creditors: In case of liquidation, reserve funds provide equal treatment for all creditors by making the resources available as allocated.
- Not an Impact on Regular Operations: Reserve funds are inactive during the operational phase of the company, ensuring they do not affect normal financial planning or distributions of shareholders unless the company is being dissolved.
- Strategic Planning Tool: This section can be used by businesses to give assurance to investors and regulators about their long term financial sustainability.
Conclusion
Section 65 of the Companies Act 2013 allows companies limited by shares to enhance their capital adequacy by transferring a portion of the uncalled share capital as reserve capital. The reserved liability, which is employed only during winding up, assists in securing creditors and enhancing the creditworthiness of the company. Though it does not influence routine business activities, it is essential in case of insolvency as it gives a secondary source of finance. Section 65 is therefore a prudent fiscal safeguard integrated into India’s corporate governance legislative system.
