Explain the regulatory Protection of Creditors

Question

Explain the regulatory Protection of Creditors?

Answer 1

Because of limited liability, a creditor's only protection is the fund of assets owned by the corporation. Therefore, two types of rules have been designed to preserve the capital of a corporation:

1. The solvency test – A corporation is prohibited from making any payment to its shareholders when it is insolvent. A corporation becomes insolvent when it has liabilities in excess of the realizable value of its assets or when it is unable to pay its debts as they come due. A corporation also cannot make any payment to its shareholders that would render the corporation's assets insufficient to pay the outstanding claims of creditors at that time.

2. The maintenance of capital test– A corporation is prohibited from "returning capital" to shareholders (e.g., by payment of excessive dividends or repurchasing corporate shares) if it depletes the capital fund made up of the assets paid into the corporation by the shareholders.

If the directors violate either of these two tests, they might become liable for debts of the corporation.