The Companies Act No.

7 of 2007
INTRODUCTION
The Companies Act No. 7 of 2007 [hereinafter the “Act”] marked a significant milestone
in the development of company law in Sri Lanka for many reasons. Firstly, it results in a
significant paradigm change to the foundation of company law by moving away from its
traditional affiliation to the company law in England and aligning itself to a legal system
based on a model that exists in Canada and New Zealand.1 Secondly, it introduced
several crucial changes by eliminating some fundamental concepts that had formed the
essence of our company law, and substituting other concepts in their place. Thirdly, it
results in modernizing company law in Sri Lanka, and at least theoretically, placing it
ahead of its counterpart laws in the rest of South Asia. Though there are positive aspects
to the law, it is not without defects. The Act has been widely criticized, not only for its
content, but also the manner in which it was formulated and adopted. These factors
necessitate a critical examination of the substance of the Act and the process by which it
was adopted. .

ORIGINS OF THE ACT

It is fundamentally important to have a reasonable insight into the history of our company
law in order to understand the issues that the Act raises. Company law in Sri Lanka has
traditionally been based on the law of England. The law of England was first introduced
to Sri Lanka by the Civil Law Ordinance of 1853 which provided that “…in all questions
or issues which may (hereafter) arise or which have to be decided in Ceylon with respect
to the law of ….. corporations…the law to be administered shall be the same as that
administered in England in the like case, at the corresponding period, if such question or
issue had arisen or had been decided in England, unless in any case, other provision is or
shall remain by any enactment (now) in force in Ceylon or hereafter to be enacted”.2

Following the enactment of this Ordinance, the English Company Law was gradually
introduced to Sri Lanka by several enactments.3 However, this was generally an
unsatisfactory process since the legislature was slow to respond in codifying ongoing
developments in England. In fact, since 1948 until 1982 there were few introductions of
the developments in England into our company law. Our courts have also been slow to
respond to the changes that have taken place in England, with very few judgements being
made on company matters relating to the substantive law.

In 1982, Sri Lanka adopted the Companies Act No. 17 of 1982. This law was however,
based on the English Companies Act of 1948 and effectively resulted in the adoption of a
law which was outdated by at least four decades, even at birth.4

1
The Companies Act No. 7 of 2007 repeals the Companies Act No. 17 of 1982, the Companies (Special
Provisions) Law No. 19 of 1974 and the Foreign Companies (Special Provisions Law No. 9 of 1975.
2
Section 3, Civil Law Ordinance No. 5 of 1852.
3
These are the Joint Stock Ordinance No. 4 of 1861; Ordinance No. 4 of 1888; the Joint Stock Companies
Ordinance No. 3 of 1893; the Joint Stock Banking Ordinance No. 2 of 1897; the Companies Ordinance
No. 51 of 1938; Ordinances No. 6 of 1939; 19 of 1942; 54 of 1946; Act No. 58 of 1949; Act No. 35 of
1951; Act No. 15 of 1964; Act No 18 of 1965 and the Companies Act No. 17 of 1982.
4
It is important to note that the law of England was substantially amended in 1985 and in 1989. However,
these amendments did not find their way into our statutes.

1
In the late 1980’s and the early 1990’s there was a marked increase in the commercial
and economic activity in the country, resulting in intense pressure being made on the
resurrection of its dormant capital and financial markets. Although the Government took
several measures to improve the operational and regulatory infrastructure to facilitate
such development by means of encouraging the restructuring of the Colombo Stock
Exchange, the establishment of the Securities and Exchange Commission5 and other
complementary bodies such as the Sri Lankan Accounting and Auditing Standards Board,
and the implementation of an aggressive privatization program, no corresponding
developments were made in respect of company law. This often led to problems for the
private sector i.e., the “engine of growth”. Though forced to compete for financing on
commercial terms, the private sector was required to be innovative in formulating modern
financing techniques. Additionally, the law was also required to provide adequate
comfort to investors that their interests would be preserved. However, the law often
proved to be lacking in these respects. Eventually, on or around 1993, the government
was compelled to address this problem by commissioning the formulation of a new
Companies Act.

FOUNDATIONS OF THE ACT

One of the initial issues that had to be confronted in formulating the new law was the
selection of a model on which it could be based on. Although the natural and popular
inclination was to base it on English Law there were several factors that decided
otherwise, and the Act was finally based on a model which was closely aligned to the
1993 Companies Act of New Zealand.

The selection of the New Zealand model was neither accidental nor arbitrary. Though it
is widely believed that the professional background of the author of the Act, Mr. David
Goddard6 weighed in on the decision, this is probably an overstatement. In fact, Canada
had had a similar experience in identifying a suitable model when they sought to
modernize Canadian company law. Having rejected the English model due to the
increasing influence of the European Community directives on the English Law, Canada
elected to formulate a home grown model, in the form of the Canadian Business
Corporations Act, containing elements of company law from the United Kingdom and the
United States. New Zealand, which went through a similar process of soul searching,
based the New Zealand Act of 1993 primarily on the principles contained in the Canadian
Business Corporations Law.

ISSUES ARISING DURING THE PASSAGE OF THE LAW

When the original consultation draft of the Act was released for public comment in 1995,
it immediately ran into a storm of opposition. Apart from objections to various
substantive provisions in the draft, vehement objections were also raised to the
suggestion that our company law should depart from its affiliation to English Law. The

5
The Securities and Exchange Commissions Act No 17 of 1987 as amended.
6
The first drafts of the law were formulated by David Goddard, who had been commissioned by the World
Bank for the purpose. Mr. Goddard was a lawyer practicing in New Zealand and had been closely
associated in company law reform in New Zealand.

2
debate raged for over twelve years. Consequently, it was only in May 2007 that the law
was finally passed in Parliament. Although the law is now in operation, there remains a
considerable amount of concern on the procedures that were followed in adopting the
law; certain substantive provisions in the law; and the lack of preparation for the
implementation of the law.

PROCEDURAL CONCERNS
One of the fundamental concerns that were highlighted during the process of formulating
the law and its eventual enactment, was the lack of inclusion, consultation and
transparency. When the original drafts of the law were being formulated, there was a
serious concern that stakeholders’ opinions were excluded in determining the selection of
a model for the new law. Though there was justification for the identification of New
Zealand law for the eventual model, it was believed that due consideration should have
been given to the fact that the “market” was accustomed to English Law. Had this
fundamental issue been recognized, and proper consultation been engaged in, much of the
opposition to the law could have been avoided and the more focus could have been
placed upon its substantial issues .

Additionally, the failure of the authorities to effectively address public concerns on the
law, and to create sufficient awareness regarding the need for the law and its benefits also
stood out during this process. As it will be seen, the Act introduces several modern
concepts which in fact resulted in a paradigm change. In these circumstances, the
inability of the authorities to explain these provisions effectively aggravated opposition to
the law. Had this been achieved, and powerful professional bodies such as the Bar
Association of Sri Lanka and the Institute for Chartered Accountants in Sri Lanka been
co-opted into the process, public opinion may have been turned around to support the
provisions of the new law.

The third facet to this process was the reaction of policy makers to criticism. Faced with
intense criticism, the Company Law Advisory Commission which had by then taken over
the responsibility for ensuring the passage of the law, withdrew the drafts from
circulation in what was widely perceived as an effort to prevent further criticism of the
drafts. Withdrawal of the drafts at a crucial point prevented comprehensive discussion on
the substantive provisions of the law prior to its enactment by Parliament. The law in
itself was rushed through Parliament and made operative without sufficient lead time for
the market, the industry, regulators and other stakeholders to implement necessary
infrastructure to deal with and comply with the new requirements. The confusion and
uncertainty in which the law was made operative was clearly evidenced by the fact that
copies of the Act were not available at the Department of the Government Printer for at
least a fortnight after it effectively became law. Additionally, there was no attempt
whatsoever to adapt or harmonize other laws and regulations such as the listing rules of
the Colombo Stock Exchange, which were complementary to the Companies Act, prior to
the operation of the Act. These failures resulted, and in many instances, continue to result
in severe hardship and inconvenience to stakeholders and the market.

3
This experience clearly highlights several issues. These are: the need to create a sense of
ownership where laws of this nature are formulated; the need to effectively create public
awareness and the dissemination of necessary information to stakeholders so that the law
itself is comprehensively discussed to address stakeholder concerns; the need for
preparatory groundwork prior to such laws being made operational; and, the absolute
need for public awareness and sufficient lead times for a successful implementation and
adoption of such a law.

SUBSTANTIVE ISSUES
As previously mentioned, the Act introduces several new concepts to our company law
thus reflecting the changes that have taken place within the mature or maturing systems
of company law. Many of the changes were inevitable changes which reflect recognition
of modern commercial realities. On the other hand, there is concern that some of the
changes introduced by the Act, though suitable in other mature jurisdictions, may not the
appropriate for Sri Lanka in view of its economic and social climate.

Briefly, the major changes introduced by the Act are:

• a shift of stakeholder rights from “contract” to “statute”;

• the elimination of long existing concepts and principles which formed the
bedrock of company law in Sri Lanka;
• the relaxation of restrictions that existed under the previous law and the
provision for greater flexibility to incorporate companies and to manage
their operations;
• the introduction of new concepts relating to capital and distributions; and
the codification of the duties of directors;
• the strengthening of stakeholder rights for the purpose of creating greater
balance in the rights of stakeholders; and,
• the provision of alternative dispute resolution procedures.

A SHIFT OF STAKEHOLDER RIGHTS FROM “CONTRACT” TO “STATUTE”

The Act introduces a significant change in stakeholder relations by shifting their rights
from contract to statute. Previously, stakeholder rights in companies were based on
“contract” through the company’s articles of association. The Act introduces a
fundamental change to this model by introducing an element of “self help”, by granting
shareholders and directors the right to enforce the provisions of the Act through private
prosecutions and private actions. This approach is pragmatic and realistic, considering
that experience has clearly demonstrated that the external regulator, i.e., the Registrar of
Companies has proven to be ill equipped to effectively ensure compliance with the
provisions of the law.

THE INTRODUCTION OF NEW CONCEPTS OF COMPANY LAW

ELIMINATION OF THE REQUIREMENT OF A MEMORANDUM OF ASSOCIATION
The Act dispenses with the requirement of a Memorandum of Association which, under
the previous regime on Company Law, specified the Authorized Share Capital of the
company and the Objects Clause.

4
The elimination of the Memorandum of Association simplifies the incorporation process
by reducing the paperwork required for an application for incorporation.

ELIMINATION OF AUTHORIZED CAPITAL

The specification of the authorized capital of the company made no commercial sense.
Authorized capital merely specified the maximum amount of shares that could be issued
by the company calculated on the basis of the par value of the shares. Any increase above
that limit required a special resolution of the company. Since the calculation was based
on par value and the elimination of par value the concept has lost its relevance in modern
company law.

ELIMINATION OF THE OBJECTS CLAUSE

The elimination of the objects clause has been a major step forward in the context of the
development of company law. The historic origins of the requirement of a statement of
objects can be traced to a time in which the corporate form was a questionable form of
doing business and courts sought to place some control on the range of activities carried
on by them. In a nutshell, the effect of the requirement was that any act of the company
outside the objects was rendered ultra vires.

However, the objects clause has been made redundant in modern company law since
most companies have extremely wide objects clauses. It has also been widely
acknowledged that the requirement places unnecessary costs on business by requiring
those who engage in transactions with companies to examine the constitutional
documents of companies to determine whether the particular company has the power to
engage in that particular transaction.

The Act therefore dispenses with the need for an objects clause and grants companies the
capacity to carry on or undertake any business or activity or do any act or enter into any
transaction. It also confers them with all the rights, powers and privileges necessary for
that purpose, subject to any provisions of any written law of Sri Lanka or of any other
country.7

Although this has been subject to some criticism, the elimination of the requirement has
positive aspects. As stated above, the requirement was practically redundant. Although
the Act dispenses with the mandatory requirement of an objects clause, a company may
voluntarily opt to specify objects in its articles, in which event, it will be restricted to
such activity and business, unless expressly provided for otherwise in the articles.
However, the inclusion of such a restriction does not affect third parties or the capacity
and powers of the company. Furthermore, it does not invalidate any act, contract or other
obligation entered into by it, or any transfer of property from or to it. The doctrine of
ultra vires therefore no longer applies to a third party that does business with a company.
However, such restrictions are not entirely without effect. A shareholder or a director
may obtain a restraining order against the company from acting inconsistently with such
restrictions, unless the company has contracted or entered into a binding obligation to do
7
Section 2.

5
so. In addition to this, directors will also be personally liable for the contravention of the
articles.8

ELIMINATION OF PAR VALUE OF SHARES

Prior to the operation of the Act, shares had to be issued with a nominal or par value and
companies had to designate the value of the shares when they were issued. Once a share
was issued with a particular par value, the company could not issue shares thereafter at
less than that value, except with the consent of court, even though the actual value of the
shares had increased or decreased. This rule, which was an ingredient of the capital
maintenance doctrine, was illusory and meaningless. Unless the company was suspended
in time, the market value of its shares would have either increased or decreased
depending on its performance. If performance had improved, new shares could be issued
at a premium. On the other hand, if the company had underperformed, it was prevented
from issuing further shares because shares could not be issued at a price below par value.
The par value rule has therefore been subjected to substantial criticism for many decades,
and several countries have abandoned the concept when reforming their company law.

The Act has followed suit by specifically providing that no share shall have a nominal or
par value.9 Shares must now be issued for consideration which the board of directors
resolve is fair and reasonable to the company and to all existing shareholders.
Consideration can be in any form including cash, promissory notes, future services,
property of any kind or securities of the company.10

Although this rule has caused some concern in the market, it is undeniably a move in the
right direction as it reflects the latest trends in modern company law. The principles
contained in the rules are commonsensical and practical, and is a huge improvement from
the theoretical concept of par value.

ABOLITION OF THE CONCEPT OF “PEOPLES COMPANIES”

The previous law made provision for “peoples companies”. Peoples companies were
introduced by Act No. 17 of 1982 for the purpose of encouraging investment in small
scale ventures, by limiting maximum ownership in the shares of the company to ten
percent and requiring a broad based system of ownership by mandating at least fifty
shareholders in such companies. Despite the legislative intent in providing for such
companies, the facility was hardly utilized. Moreover, had been decided that the
legislature could achieve similar results more effectively, through fiscal measures.

RELAXATION OF RESTRICTIONS AND THE PROVISION FOR GREATER FLEXIBILITY

INCORPORATION PROCEDURE SIMPLIFIED

One of the primary objects of the Act is the simplification of procedures in order to
reduce expenses and procedural complexity. These measures have been sought to be
achieved through the following:

8
Section 17.
9
Section 49.
10
Section 52.

6
REQUIREMENT OF A MEMORAUNDUM HAS BEEN ABOLISHED
This aspect has been discussed above. Accordingly, the sole constitutional document of a
company today is its articles of association.

RIGHT TO ADOPT MODEL ARTICLES

The Act has simplified the incorporation process even further by providing companies
with a choice of either having their own articles or opting to adopt the model articles of
the Act, unless they are companies limited by guarantee.11 If they elect for the former, the
articles can provide for any matter not inconsistent with the Act, including objects, rights
and obligations of the shareholders, management, and administration of the company.12

Although the Act seeks to simplify the incorporation procedure by offering the option of
adopting the model articles, in practice, most promoters will opt to incorporate specific
rights and duties in the articles. These could include special rights of shareholders on the
appointment of directors, veto powers and pre-emptive rights on the disposal of shares. In
such instances, the model articles are unlikely to cater to such requirements. It is also
likely that companies which are incorporated for special purposes, for example, Banks,
Broking Firms etc., or those that are granted special incentives based on operational
activity, for example, companies approved by the Board of Investment, would be
required to specify objects by the regulatory authority which have purview over them.

This new procedure is a progressive step, resulting in the elimination of the need for
name approvals from the registrar. Apart from reducing delays, it also removes any
discretion that the registrar may have had under the previous regime.

SINGLE SHAREHOLDER COMPANIES

Previously, a public company was required to have a minimum of seven shareholders,
and a private company was required to have a minimum of two.13 The Act takes a bold
step by introducing the concept of single shareholder companies. Although the concept of
a single shareholder company was recommended in the original drafts of the law, it was
shelved in the latter drafts due to opposition. The compromise reached and reflected in
the Bill was that single shareholders should be permitted, if they were a body corporate or
the Secretary to the Treasury. However, consequent to an amendment at the Committee
Stage, provision was made for companies to be incorporated with a single shareholder,
who can be an individual, a body corporate or the Secretary to the Treasury holding
shares on behalf of the Government of Sri Lanka.14

The concept of a single shareholder company has its merits and demerits. The rationale
for the provision is that it will encourage sole proprietorships to convert into companies.
11
Section 14.
12
Section 13.
13
The requirement of seven subscriber shareholders was considered redundant and senseless. In practice,
promoters would enlist seven persons to take a single share each to make up the required number. After
the incorporation of the company, the subscriber shareholders or a majority of them would have no further
interest or participation in the company.
14
Section 4.

7
Although, it reflects commercial and practical reality in that most companies effectively
have a single controlling shareholder with the remainder owning negligible shares and
playing no role whatsoever in the operations of the Company, there are genuine concerns
of the consequences that would arise upon the death of a single shareholder.

GREATER FLEXIBILITY FOR OPERATIONS OF PRIVATE COMPANIES

The Act recognizes the importance of providing “start up entrepreneurs” with the ability
to operate under the corporate form without having to deal with unduly burdensome
administrative responsibilities. Accordingly, private limited companies, which are usually
the vehicles utilized by such entrepreneurs, are given a considerable degree of informality
in their management, and are permitted to dispense with certain formalities prescribed by
the Act with the consent of all the shareholders. Thus, the shareholders may unanimously
resolve to dispense with the Interests Register, provided that any shareholder may, by
written notice, require its reactivation.15 The Act also codifies the common law principle
known as the Re Duomatic principle which means that a company would normally be
bound by the informal agreement of all of its voting members. Accordingly, if all the
shareholders of a private limited company agree in writing to any action that has been or
is to be taken by the company, that action is deemed valid, despite any contrary provision
in the articles. Further, it exempts private limited companies from complying with the
provisions specified in the Second Schedule to the Act. These sections relate to
consideration for the issue of shares (section 52); pre-emptive rights to new issues
(section 53); distributions (section 56); dividends (section 60); recovery of distributions
(section 61); purchase of its own shares (section 64); restrictions on giving financial
assistance (section 70); exercise of powers reserved to shareholders (section 90); powers
exercised by special resolution (section 92 (1)[b]); alteration of shareholder rights
(section 99); major transactions (section 185); disclosure of interests (section 192);
avoidance of transactions (section 193); remuneration and other benefits (section 216);
restrictions on loans to directors (section 217); and, indemnity and insurance (section
218). Moreover, flexibility is granted to the shareholders of a private limited company to
agree to or concur in: the issue of shares or the making of a distribution by the company;
the repurchase or redemption of shares; the giving of financial assistance by a company
for the purpose of, or in connection with the purchase of its shares; the payment of
remuneration to a director; or the making of a loan to a director; or the conferment of any
other benefit on a director, or the entering into a contract between an interested director
and the company.

However, if a private limited company makes a distribution which results in the company
failing to meet the solvency test, the distribution shall be deemed invalid. The company
may recover the distribution from the shareholders, unless the shareholder: received it in
good faith without knowledge that it would result in such failure; the shareholder has
altered his position in reliance of such distribution; and it would be unreasonable in view
of the circumstances to require such repayment. Any outstanding amount may be
recovered personally from all shareholders who agreed to such a distribution without
having reasonable grounds to believe that the company could satisfy the solvency test

15
Section 30.

8
after the distribution. A court may however reduce the amount to that which permits the
company to maintain the solvency level.16

SIMPLIFICATION OF OPERATIONAL PROCEDURES

The traditional approach to the regulation of corporate affairs placed emphasis on
restricting the freedom of companies in many areas on the premise that those who dealt
with companies had to be protected. These included restrictions on: the reduction of
capital; purchase of own shares; right to provide financial assistance for the purchase of
own shares, based on the capital maintenance doctrine. However, the capital maintenance
rule is widely considered to be anachronistic because it is based on the unreal notion that
creditors trade with companies on the basis of their issued capital. Apart from the fallacy
of the premise itself, it has restrictive practical consequences, for example, it compels
companies to retain subscribed capital without distributing it to shareholders even when
the shareholders could put the funds to better use; prevents companies from buying back
their own shares, pay dividends out of capital, or give financial assistance for the
purchase of their shares and thereby limits the ability of companies to implement modern
financing techniques. Consequently, the capital maintenance rule has been abolished in
many jurisdictions, including Canada and New Zealand, which form the fundamental
models for our present law.

The Act follows this approach by placing greater responsibility on the directors of the
company. Directors are guided by a simple principle, i.e., the requirement that they
should always ensure that the company meets the “solvency test”, which is a new concept
introduced to our law by the Act.

The new approach removes many of the procedural requirements that were mandatory
previously. Accordingly:

REDUCTION OF STATED CAPITAL

A company may by special resolution, reduce its stated capital to an amount it
thinks appropriate in compliance with the provisions of the Act. The Act requires
that public notice of the proposed reduction be given at least sixty days prior to
the resolution being passed so that those dealing with the company are aware of
the proposed reduction. However, if the company has agreed in writing to refrain
from reducing its stated capital below a specified amount without a creditors prior
consent or the satisfaction of specified conditions, a resolution passed without
such consent or satisfaction of conditions shall be invalid and of no effect.17

This procedure releases companies from being required to comply with the time
consuming and often cumbersome formalities required under previous law, i.e.,
special resolutions and the sanction of court.

REPURCHASE OF SHARES

16
Section 31
17
Section 59.

9
 Previously, the law did not permit companies to purchase or acquire their own
shares. However, the Act relaxes this prohibition by permitting companies to
purchase and acquire their own shares in specific situations. However, the term
“repurchase” is somewhat misleading. When a company acquires or redeems a
share under the Act, the share is deemed to be cancelled immediately upon its
acquisition or redemption.18 Consequently, even though the company pays
consideration for the share, the share is not transferred back to the company.
Effectively, it is no more than a distribution of assets to shareholders, and the law
treats it as a distribution by requiring the solvency test to be satisfied. Once a
share is repurchased, the repurchased capital is removed from the balance sheet, a
credit is made to the cash account, and an off-setting entry is made to the stated
capital (shareholder equity) account as a debit.19

When a company purchases its own shares it must satisfy certain conditions and
must follow a prescribed procedure. The articles of the company must provide for
such purchases. The purchase, or agreement to purchase, should also be approved
by the board after it resolves that the acquisition is in the interests of the
company; that the terms of the offer or agreement and consideration are fair, and
in the opinion of the company’s auditors, a fair value; and that the board is not
aware of any material information relating to the assessment of such value that
has not been disclosed to the shareholders which makes it unfair to shareholders
who accept the offer. If the acquisition or agreement to acquire relates to only
some of the shareholders but will consequently affect the relative voting and
distribution rights, the board must also resolve that the offer or agreement is fair
to those shareholders to whom the offer is not made.20

A contract by a company to acquire its own shares will be specifically enforceable

against it, except to the extent that it would result in a failure of the company to
satisfy the solvency test after its performance. The burden is on the company to
prove that fact. Until the company performs the contract, the other party retains
the status of a claimant entitled to be paid no sooner than the company is lawfully
able to do. If the company is liquidated, the claimant will be ranked subordinate to
creditors but in priority to shareholders. Where a company acquires or redeems its
own shares the share is deemed to be immediately cancelled and the Registrar
must be informed of the cancellation.21 The Act therefore does not recognize or
permit “treasury stock”.

FINANCIAL ASSISTANCE FOR PURCHASE OF OWN SHARES

18
Section 63.
19
See, McGuinness, K.P, The Law and Practice of Canadian Business Corporations, Butterworths,
(Canada) [1999] pg 395.
20
Section 64. The board carries a heavy responsibility when it resolves that it is unaware of any material
information that has not been disclosed to the shareholders relating to the assessment of the value of the
shares, and / or that the offer or agreement is fair to those shareholders to whom the offer is not made,
since the board will be an “insider” to the transaction. This requirement is meant to deter directors from
abusing the power of repurchasing shares through the company.
21
Section 63.

10
 Until the passage of the Act, the law restricted the circumstances in which a
company could give financial assistance for the purpose of or in connection with
the purchase of its own shares.22 Such assistance could only be given if lending
money was a part of the ordinary business of the company, or it was provided by
the company for the purchase or subscription of fully paid shares in the company
or its holding company, under an employee share scheme, or as a loan to
employees in the bona fide employment of the company for the purchase of the
company’s shares.23

The Act takes a two pronged approach in regulating the manner in which a
company may grant financial assistance for the purchase of its own shares. Firstly,
it lays down specific formalities that must be followed by a board in granting
direct financial assistance for the purchase of its own shares. Secondly, it expands
the classes of transactions in which those procedures may be dispensed with,
following the model in section 153 of the English Companies Act of 1985.

A company may give direct or indirect financial assistance for the purpose of, or
in connection with, the acquisition of its own shares if it complies with the
formalities set out in section 70 of the Act. In order to comply with these
formalities, the board must resolve that such assistance is in the interests of the
company; that the terms and conditions of such assistance are fair and reasonable
to the company and those shareholders not receiving such assistance; and, that the
company will satisfy the solvency test immediately after giving such assistance. If
financial assistance, inclusive of other outstanding amounts so given, exceeds ten
percent of the stated capital, the company must first obtain a certificate stating
that the board’s belief that the company will satisfy the solvency test is not
unreasonable. This certificate must be given by the company’s auditor, or if there
is no auditor, a person qualified as act as such.

The granting of financial assistance under section 70 is not treated as a

distribution for the purpose of section 56. However, non compliance with the
formalities contained in section 70 leads to severe penalties by making every
officer of a company in default liable to a fine of up to a million rupees and
imprisonment up to five years, or both.24 The Act specifies certain circumstances
where the provisions of section 70 do not apply. Accordingly, if the principal
purpose for which financial assistance is given is not for the acquisition of the
company’s shares, or if the assistance is given as an incidental part of any other
larger purpose of the company, such assistance is exempted from the provisions
of section 70, provided that the company gave it in good faith in the interests of
the company.

22
The rationale for this restriction was two fold. Firstly, if the company failed after giving funds or a
guarantee for the purchase of its own shares, its position would be severely jeopardized. Secondly, such
facilities could be abused by directors for the purpose of furthering their own interests and consolidating
control.
23
Section 55 of the Companies Act No. 17 of 1982.
24
Section 70.

11
 The Act also excludes specific transactions from the ambit of section 70. These
are: distributions to shareholders approved under section 56 of the Act; issues of
shares by the company; repurchases or redemptions of shares by the company;
and anything done in terms of a compromise with creditors under Part IX, or a
compromise or arrangement approved under Part X of the Act. The Act also
preserves the exemptions that existed under the previous law by exempting from
the provisions of section 70, the granting of financial assistance by a company for
the purchase of its shares when the company’s ordinary business includes lending
money, and it does so in the ordinary course of business; the provisions of
financial assistance for an employee share scheme, if it is provided in good faith
in the company’s interests; or the granting of a loan to employees, other than
directors, to enable them to acquire beneficial ownership of shares in the
company, provided that it is granted in good faith in the company’s interests.25

The relaxation of restrictions that existed previously is a recognition of the new

approaches for the treatment of capital. They are, by and large, pragmatic, granting
companies freedom to determine the best use of resources, provided that there is
compliance with the basic requirements that ensure that the interests of other stakeholders
will not be undermined. However, these procedures cast a heavy responsibility on
directors and the failure to create sufficient awareness of these responsibilities and the
consequences of non compliance could lead to problems in the future.

INTRODUCTION OF THE CONCEPT OF STATED CAPITAL AND THE SOLVENCY TEST;

STATED CAPITAL
The principle of stated capital replaces the concept of issued share capital under the
previous regime.26 The stated capital of a company is the total amount received by it, or
due and payable to it, in respect of the issue of shares and calls on shares. If the shares are
issued for consideration other than cash, the board must determine their cash value for the
purpose of calculating stated capital. If a share has an obligation attached to it other than
an obligation to pay calls, the board must determine the cash value of that performance
and such performance shall be deemed to be a call paid on that share for computing stated
capital.27

This is yet another progressive feature in the new law since the concept of issued share
capital was misleading and did not reveal the actual amounts received by the company
through the issue of shares.

THE INTRODUCTION OF THE SOLVENCY TEST

The solvency test has acquired a critical role in jurisdictions such as New Zealand,
Canada and the United States as a result of the abolition of the capital maintenance rule.

25
Section 71.
26
Under previous law, “issued share capital” equalled the number of shares issued and multiplied by the
par value. When shares were issued at a price higher than par, that excess was credited to a “premium”
account.
27
Section 58. .

12
However, the solvency test, as applied by the laws in New Zealand, Canada and the
United States, merely requires that companies should be able to pay their debts as they
become due in the normal course of business (i.e., the “equity” or “liquidity” test) and to
ensure that their assets are greater than their liabilities (the “balance sheet” test).
Although the wording of our Act is almost identical to the wording in the New Zealand
Companies Act of 1993, the addition of a single phrase to the section results in the capital
maintenance rule being embedded in the definition of the solvency test. It is vital that this
distinction between the laws in jurisdictions such as Canada and New Zealand, and our
law be borne in mind before seeking to apply the practice and precedent of such
jurisdictions in Sri Lanka.

Under the Act, the solvency test is deemed satisfied if the company is able to pay its
debts as they become due in the normal course of business, and the value of the
company’s assets are greater than the value of its liabilities and the company’s stated
capital.28 The last requirement, i.e., that the assets must be greater than the stated capital,
is unique to our law and entrenches the capital maintenance rule in the solvency test.

Although the addition of stated capital to the definition of the solvency test was probably
for the greater protection of creditors, it has resulted in a serious limitation to the freedom
of companies to make distributions. Under the previous regime on company law, the
accumulated losses of a company had no bearing on the ability of the company to pay
dividends, provided that the company had profits during the current accounting year.29
What was required was an earnings surplus based on the current year’s trading profits.
However, the definition of the solvency test under the Act changes this radically. A
company now requires not only an earnings surplus, but also assets in excess of stated
capital. In effect this means that the net position of the company would be relevant, as
would the accumulated losses and surpluses over the years.30

CODIFICATION OF DUTIES OF DIRECTORS

The law relating to the duties of directors was previously governed by common law and
the large body of case law on the subject was inaccessible to the layman. The Act seeks
to address this problem by codifying the fundamental principles that govern directors’
duties.

DIRECTORS DEFINED
A serious deficiency of the law under the previous regime was that the perception of the
concept of a director was extremely narrow, and was effectively restricted to those who
occupied formal positions within the Board of Directors. This permitted the evasion of
responsibilities by the appointment of “men of straw” as nominees to boards and
avoiding the responsibilities and liabilities under the law. The Act addresses this issue by

28
Section 57.
29
These rules were not made by the law but instead by the accountancy profession. See, L.S Sealy, Cases
and Materials in Company Law, 7th Ed. Butterworths, 2001, pg 396.
30
It appears that this follows the English approach adopted in the Part VIII of the Companies Act of 1985.
The downside to this approach is that it could discourage venture capitalists from investing in start up
companies because of the limitation on the ability to pay dividends.

13
bringing a wide group of persons within the definition of director by focusing on the
substantive functions performed by each within and in respect of the company rather than
the mere designation. Consequently, the definition covers any person occupying the
position of a director irrespective of the title of the person, including “shadow directors”
for the purpose of specific provisions of the Act.31 Shadow directors include all persons
in accordance with whose directions or instructions a director or the board of the
company would be required or accustomed to act. It also includes persons who exercise
or are entitled to exercise, or who control or are entitled to control powers, which apart
from the articles of the company, would be required to be exercised by the board. Any
person to whom a power or duty of the board has been directly delegated by the board
with that person’s consent or acquiescence, or who exercises the power or duty with the
acquiescence of the board are also deemed to be directors for the purpose of sections 187
- 195, 197, 374 and 37732. However, this extended definition for the provisions
mentioned above will not apply to a person who acts purely in a professional capacity.33

DISCLOSURE AND ACCOUNTABILITY

The Act also proceeds to specify certain disclosure requirements in respect of
transactions of directors which have a bearing on the operations of their companies. The
requirements of compliance with specified formalities which ensure transparency and
accountability are expected to increase the credibility of corporate actions.

DISCLOSURE OF INTERESTS
When a director becomes aware of an interest he has in a transaction, or a proposed
transaction, with the company he must forthwith have it entered in the company’s
interests register. The interest must be disclosed to the board if the company has more
than one director. The disclosure must set out the nature and extent of the interest. A
general notice in the interests register or to the board that the director is a shareholder,
director, officer, or trustee of another company or person, or is otherwise connected to
another company or person who has an interest, will be sufficient disclosure for the
purposes of discharging this obligation. Though the failure by a director to disclose the
interest will not affect the validity of the transaction, it will make him personally guilty of
an offence.34

The circumstances in which a director will be treated as having an interest in a company

transaction have been comprehensively defined in the Act. Accordingly, he will be

31
These provisions are: section 187, which lays down directors’ duties; section 188, which prescribes the
duty of directors to act in good faith and in the interest of the company; section 189, which imposes a duty
on directors to comply with the Act and the company’s articles; section 190, which prescribes directors’
standards of care, and the use of information and advice; section 197, which deals with the principles on
the use of company information; section 374, which deals with liabilities for fraud in anticipation of
winding up; and section 377, which lays out directors responsibilities relating to disclaimers of onerous
property.
32
See above. Sections 191-195 deal with directors interests in contracts with the company.
33
Section 529.
34
Section 192.

14
considered to have an interest in a transaction if he is a party to it, or he will or may
derive a material financial benefit from it, or he has a material financial interest in
another party to it. A director will also be considered to be interested if he is a director,
officer, or trustee of another party to the transaction, or a person who will or may derive a
material financial benefit from the transaction, provided that such party or person is not
the company’s wholly owning holding company, a wholly owned subsidiary, or another
wholly owned subsidiary of the holding company. If the director is a parent, child, or
spouse of another party to the transaction, or person who will or may derive a material
financial benefit from the transaction, he too will be within the ambit of this definition. A
director who otherwise has a direct or indirect material interest in the transaction would
also be deemed to have an interest in a transaction in which the company has an interest.
A director is not deemed to have a financial interest in a transaction to which the
company is a party if it merely consists of the company giving security to a third party
with no connection to the director, at that third party’s request, on a debt or obligation for
which the director or another person has personally assumed responsibility, whether in
whole or in part, under a guarantee, indemnity or by the deposit of a security.35

Non compliance with these provisions can have severe repercussions. The company can
have any such transaction avoided at any time within six months after the transaction and
the director’s interest in it has been disclosed to all shareholders whether through the
annual report or otherwise. However, a transaction may not be avoided if the company
has received fair value for it. Fair value will be determined on the basis of information
known to the company and the interested director at the time the transaction was entered
into. It will be presumed that fair value was received by the company if the transaction
was entered into by the company in the ordinary course of business and on usual terms
and conditions. The burden of establishing fair value shall be on the person seeking to
uphold the transaction, and knew, or ought to have known, of the director’s interest when
the transaction was entered into. In every other case the burden will be on the company to
establish that it did not receive fair value. The only grounds on which a transaction with a
company in which a director has an interest can be avoided are those specified in section
193 of the Act or in the company’s articles.36 When a company rescinds a contract, the
director must restore to the company any money or benefits received under it.

However, the Act preserves the common law protection of third parties who, in good
faith and without notice of the circumstances that give rise to that equity, receive property
with an equity in favour of the company. Accordingly, the right to avoid a transaction
under these provisions shall not affect a person’s title to, or interest in, property which
that person acquired from a person other than the company, for valuable consideration,
and in good faith without notice of the circumstances that make the transaction
voidable.37

Certain transactions are exempted from this requirement. Neither remuneration and
benefits given to a director under section 216, nor indemnities and insurance provided

35
Section 191.
36
Section 193.
37
Section 194.

15
under section 218, require disclosure under section 192 or can be subject to avoidance by
the company under section 193 of the Act.38

DISCLOSURE OF DIRECTORS’ INTERESTS IN SHARES

Directors who have a relevant interest in any of the company’s shares are required to
immediately disclose the number, class and nature of the interest in such shares to the
board and also enter such particulars in the interests register. This is a continuing
obligation and applies to any subsequent acquisitions or disposals, with details of the
nature of the relevant interest, the consideration paid or received, and the date of the
acquisition or disposal.39

The term “relevant interest” has been given an extremely wide meaning in the Act and
extends beyond beneficial ownership. A director is deemed to have a relevant interest in a
share if he has the power to exercise, or to control the exercise of, any right to the vote
attached to it; or the power to acquire or dispose of the share; or the power to control the
acquisition or disposal of it by another. Such an interest is also deemed to exist if the
director has the right to exercise such powers under or by virtue of any trust, agreement,
arrangement or undertaking relating to the share, whether or not he is a party to it. This
applies regardless of whether the power is expressed or implied, direct or indirect, legally
enforceable or not, related to a particular share or not, subject to or capable of being
subject to a restraint or restriction exercisable presently or in the future, subject to
conditions precedent, or exercisable singly or jointly. The reference to a power, which
forms the criteria for a relevant interest, includes powers that arise from or are capable of
being exercised as a result of a breach of any trust, agreement, arrangement, or
understanding, whether or not it is legally enforceable. When any person has a relevant
interest in a share in terms of section 198 (1) and that person or its directors are
accustomed to, or are under an obligation (whether it is legally enforceable or not), to act
in accordance with the directions, instructions or wishes of a director of the company in
relation to the exercise or the control of the exercise of the right to vote, or the acquisition
or disposal or the exercise of the power to control the acquisition or disposition of the
share, that director is deemed to have a relevant interest in the share. Similarly, when any
person has a relevant interest in a share by virtue of section 198 (1), and a director of the
company has the power to exercise, or to control the exercise of the vote, or the power to
acquire or dispose, or control the power to acquire or dispose of twenty percent or more
shares of that person, that director is deemed to have a relevant interest in the shares.40

Though the definition of relevant interest is quite broad, the Act narrows its application
by exempting disclosure in five specified situations. The first is if the ordinary business
of the person with the relevant interest consists of or includes the lending of money or the
provision of financial services, and the relevant interest only consists of security given for
the purposes of a transaction entered into in the ordinary course of business of that
person. The second is if that person has the relevant interest only because he acts for
another in the acquisition or disposal of that share. The third situation is where the

38
Section 195.
39
Section 200.
40
Section 198.

16
relevant interest is held solely by reason of being appointed as a proxy to vote at a
particular meeting of members or a class of members of the company. The fourth
situation is where that person is a trustee corporation or a nominee company and has the
relevant interest only by reason of acting for another person in the ordinary course of
business of that trustee corporation or nominee company. The fifth situation is where the
person has a relevant interest only by reason that he is a trustee of a trust to which the
share is subject.41

RETIRING AGE OF DIRECTORS

The Act seeks to improve transparency on procedures relating to the continuation of
services by directors after they reach the age of seventy years. Firstly, the Act retains the
general provisions that existed under the previous law by providing that no person shall
be appointed as a director of a public company, or a private company that is a subsidiary
of a public company, after he has reached the age of seventy.42 He will vacate office at
the conclusion of the annual general meeting immediately following the attainment of the
age of seventy, or if reappointed after attaining such age, at the annual general meeting
following the reappointment. No provision for automatic reappointment of retiring
directors in default of another appointment will apply and the resulting vacancy may be
filled as a casual vacancy. However, at a general meeting the company may approve the
appointment or reappointment of such a person by a resolution declaring that the age
limit will not apply and that he may continue as a director. However, the Act tightens the
rule by providing that such a resolution will be valid for only one year from his
appointment and will therefore have to be adopted each year if the director is to continue
beyond the age limit. It also requires that the notice of the resolution state the age of the
director.43 Moreover, when a person reaches seventy, or is proposed for reappointment
when he has reached seventy, or a lower age as may be prescribed by the articles, he must
give notice of his age to the company. A person who fails to give notice of his age, or
acts under any appointment which is invalid, or is terminated by reason of his age, shall
be guilty of an offence.44

DISQUALIFICATION OF DIRECTORS
The Act introduces a new concept to our law on the disqualification of directors by
providing for automatic disqualification in certain instances. Where a person has been
convicted under the Act of an offence that is punishable with imprisonment, or an offence
involving dishonest or fraudulent acts, or has been adjudged insolvent under the
Insolvency Ordinance, or been adjudged to be of unsound mind, he shall not be a director
or promoter, or be directly or indirectly concerned or participate in the management of a
company for a period of five years after the conviction or adjudication, without the leave
of the court. The court has the power to grant him leave on terms and conditions it thinks
fit. Where a person seeks to obtain such leave, the Registrar must be given at least ten
working days notice, and the Registrar and others whom the court sees fit, are entitled to
be heard at the hearing of the application. A person who acts in contravention of this

41
Section 199.
42
Section 210.
43
Section 211.
44
Section 212.

17
section exposes himself to sanctions of up to one million rupees and imprisonment of up
to five years.45

In addition to automatic disqualification, the Act also provides for any person to apply to
the court for an order disqualifying another from acting as a director. The court may
make such an order if the person sought to be disqualified is prohibited from being a
director of a company under section 213 of the Act, or has persistently failed to comply
with the provisions of the Act, or has been convicted of an offence involving dishonesty
or fraud in a country other than Sri Lanka, or was a director of a company that became
insolvent and his conduct as a director in that company or another makes him unfit to be
a director. By that order, the court may prohibit such person from acting as a director or
promoter of, or from being in any way directly or indirectly concerned or participating in
the management of a company for up to ten years without leave of court.46

REMUNERATION TO DIRECTORS
Subject to the provisions of the Act that deal with loans to directors, the board may, under
authorization by the articles or approval by an ordinary resolution, approve the payment
of remuneration or other benefits to a director for services rendered as a director or in any
other capacity. If such authorization does not exist, the board may be liable to repay the
sums paid to the director, to the company, even if they acted in good faith. The board
may approve payment of compensation for loss of office to a director or former director
in compliance with similar formalities. Compensation means any payment for which
there is no legal obligation. The board may also enter into a contract for making such
payments. However, before it does so, the board must be satisfied that such payments
would be fair to the company.

The particulars of a payment or a contract for remuneration must be entered forthwith in

the interests register. However, when a payment of remuneration or a benefit is granted in
accordance with a contract that has been registered in the interest register, each payment
does not have to be entered. When directors vote in favour of such a payment, benefit, or
contract, they must sign a certificate stating that, in their opinion, it is fair to the company
and must specify reasons for their opinion. Where this procedure is not complied with,
the director or former director to whom the payment or benefit is provided shall be
personally liable to the company for the amount of the payment or monetary value of the
benefit, except to the extent that he can prove it was fair to the company at the time it was
made or provided. The articles of a company may override these requirements and allow
shareholders to authorize payments and benefits to directors, without complying with
these formalities.47

LOANS TO DIRECTORS
Subject to section 31 of the Act, which permits shareholders of private companies to take
certain decisions by unanimous agreement, and subject to specified exceptions, a
company cannot give loans to one of its directors or a director of a related company. It

45
Section 213.
46
Section 214.
47
Section 216.

18
also cannot give a quasi loan in the form of a guarantee or the provision of security in
connection with a loan made by any person to a director of the company or of a related
company.48

Certain types of loans and quasi loans are exempted. A company may give a loan to a
director if the aggregate amount advanced does not exceed twenty five thousand rupees
or a higher sum as may be prescribed by the Minister on the recommendation of the
Advisory Commission on Company Law. The law also exempts loans that are given to a
related company, or guarantees or security provided in connection with a loan given, by
any person to a related company. A company is permitted to reimburse or advance funds
to a director to enable him to meet expenditure for the company’s purposes or to enable
him to perform his duties as an officer of the company. If the company carries on the
business of lending money it may give a loan to its directors or related companies if it is
made in the ordinary course of that business.

Any loan given in contravention of these provisions is voidable at the company’s option
and shall be immediately repayable upon being voided, irrespective of any terms of
agreement. Where a transaction other than the provision of a loan to a director is entered
into by the company in contravention of the prohibition, the director will be liable to
indemnify the company for any loss or damage that arises from the transaction.
Moreover, the transaction will also be voidable at the company’s option unless the
company is indemnified by the director for any loss or damage resulting from it, or if any
rights acquired by a person other than the director, in good faith for value, without actual
notice of the circumstances giving rise to the breach of this section would be affected by
its avoidance. Additionally, the provision of a loan in contravention of these prohibitions
can result in the company, as well as directors who authorize or permit it, being found
guilty of an offence.49

INDEMNIFICATION AND INSURANCE FOR DIRECTORS

The Act seeks to clarify the law relating to the instances and circumstances where a
company can indemnify and insure its directors. The basic principle is that a company
cannot indemnify,50 or directly or indirectly effect insurance,51 for a director or
employee52 of the company or a related company in respect of any liability for any act or
omission in his capacity as a director or employee, or for costs incurred by them in
defending or settling any claim or proceeding relating to such liability.

This is subject to limited exceptions. If the company’s articles expressly grant

authorization, the company may indemnify its own directors or employees or those of a
related company, for costs incurred by them in any proceeding that relates to a liability
for an act or omission in their capacity as directors or employees, provided that judgment

48
Section 217.
49
Section 217.
50
The term “indemnify” includes relief or excuse from liability, whether before or after the liability arises,
and indemnity has a corresponding meaning.
51
“Effect insurance” includes the payment, whether directly or indirectly, the cost of the insurance. Id.
52
“Director” or “employee” includes a former director or employee. Id.

19
is given in their favour, or they are acquitted, or the proceedings are discontinued, or they
are granted relief under section 526 of the Act. Similarly, when there is express
authorization in the company’s articles, a company may indemnify its directors or
employees or those of a related company in respect of liability to any person other than
the company or a related company, for any act or omission in their capacity as directors
or employees, or costs incurred by them in defending or settling any claim or proceeding
relating to such liability, provided that such liabilities are not criminal liabilities, or in the
case of directors, in respect of a breach of the duty to act in good faith and in the interests
of the company.

If the articles expressly authorize, a company may, with prior board approval, effect
insurance for a director or an employee of the company or a related company in respect
of specified liabilities. The specified liabilities are any acts or omissions in their capacity
as directors or employees provided that the liability is not criminal liability; costs that
may be incurred by them in defending or settling any claim or proceeding relating to such
liability; and costs in defending any criminal proceedings in which they are acquitted.

The board must forthwith enter the particulars of such indemnities or insurance in the
interests register. An indemnity given in breach of these provisions shall be void.
Moreover, the director or employee for whom the insurance is effected shall be
personally liable to the company for the costs of effecting insurance if these provisions
are not complied with, unless he can prove that it was fair to the company at the time it
was effected.53

DIRECTORS DUTIES ON INSOLVENCY

If a director believes that the company is unable to pay its debts as they fall due, he must
immediately call a board meeting to consider whether the board should apply to the court
to wind up the company and to appoint a liquidator or administrator, or whether the
company should continue its business. If a director fails to do so and the company is
subsequently placed in liquidation, a court may, on the application of the liquidator or a
creditor of the company, order that the directors be held liable for the whole or part of
any loss suffered by the creditors as a result of the company continuing its business.

If the board does not resolve to appoint a liquidator or administrator at the meeting, and
there were no reasonable grounds for believing that the company could have paid its
debts as they fell due at the time of the meeting, and the company is subsequently placed
in liquidation, a court may, on the application of the liquidator or creditor, order that the
directors, other than those who voted for the appointment of a liquidator or administrator,
be liable for any loss suffered by creditors as a result of the company continuing to carry
on its business.54

DUTY OF DIRECTORS ON SERIOUS LOSS OF CAPITAL

If it appears to a director that the company’s net assets are less than half its stated capital,
the board must call an extraordinary general meeting within twenty working days of the

53
Section 218.
54
Section 219.

20
director becoming aware of the fact. The meeting must be held not later than forty
working days from the date it is called. The notice of the meeting must be accompanied
by a report from the board advising shareholders of the nature and extent of losses
incurred, causes for such losses, and the steps that the board has taken to prevent further
losses or to recoup losses already incurred. The chairperson of the meeting must ensure
that adequate opportunity is given to shareholders to ask questions in relation to, and to
discuss and comment on, the report and the management of the company generally.55

STRENGTHENING OF STAKEHOLDER RIGHTS

The Act has made significant changes in respect of stakeholder rights, expanding the
definition of shareholders and giving them greater powers and access to remedies.

Previously, there was some confusion on the use of the terms shareholder and member.
The Act clarifies these issues by providing a comprehensive definition of the term
shareholder. A shareholder is a person whose name is entered in the share register as the
holder of a share for the time being. The definition also extends the ambit of the term to
certain cases where a person’s name is not entered in the share register. Accordingly,
“shareholders” include persons named as shareholders in an application for incorporation
of a company at the time of its registration; persons entitled to have their names entered
in the share register as shareholders of an amalgamated company under an amalgamation
proposal; and persons to whom shares have been transferred and whose name ought to
be, but are not, entered in the share register. Persons whose shares are held in an
approved Central Depository System are also deemed to be shareholders of the company
to which the shares relate to and are entitled to the rights and privileges and are subjected
to all duties and obligations of shareholders as if their names were entered in the share
register. If a company wrongfully fails to enter the name of the person to whom shares
have been transferred in the share register, that person shall nevertheless be deemed to be
a shareholder and shall enjoy the rights and privileges and shall be subject to the duties
and obligations as if his name was entered in the share register.56

The clarification of the status of shareholders is a useful development since it removes a

serious source of uncertainty in respect of shareholder rights. However, these new
provisions will require that the provisions of other statutes and regulations, such as those
in the Banking Act, be amended appropriately.

INTRODUCTION OF SHAREHOLDER RIGHTS AND REMEDIES

RESTRAINING ORDERS
The Act contains another powerful tool by way of a statutory right for restraining orders
for preventing contraventions of its provisions and those of the articles. This right is
available to the company, a director or a shareholder of the company. Accordingly, any
of them may apply to the courts for an order restraining the company or a director from
engaging in conduct that would contravene the articles or the Act. The courts are also

55
Section 220.
56
Section 86.

21
empowered to grant consequential relief as a part of the final order. Since restraining
orders are preventative, they may not be made in respect of any conduct or a course of
conduct that has been completed. It has also been held that restraining orders should be
confined to rectifying simple mechanical omissions of a type that lend themselves to
summary disposition. The court is empowered to make, as an interim order, any order
that it is entitled to make as a final order. Interim orders may, at the discretion of the
court, be made ex parte or after giving notice to the respondent. The respondent may
apply for a revocation or variation of the order with notice to the petitioner. The Act
specifically excludes the application of the provisions of section 521 of the Act, which
lays out general procedures for interim relief, to procedure under section 233 of the Act.57

DERIVATIVE ACTIONS
The Act takes another significant step in furthering shareholder rights by introducing a
statutory derivative action. Though the right to a derivative action had been recognized in
Sri Lanka, there was uncertainty as to if and when a court would exercise such powers.
The Act follows the basis adopted by the Canadian Business Corporations Act and
entrenches the derivative action as a statutory right with precise procedural and
substantive requirements. This approach has been replicated in the New Zealand Act,
which forms the primary framework for our Act. Consequently, the Act permits a
shareholder or a director to apply to court for leave to bring proceedings in the name of
and on behalf of the company or any subsidiary of the company. Leave may also be
sought from court to intervene in proceedings to which the company or any subsidiary is
a party, for the purpose of continuing, defending, or discontinuing the proceedings on
behalf of the company or subsidiary. The action is therefore not an action that may be
proceeded with as a matter of right, but is instead an action that requires the leave of
court.58

RATIFICATION
It is a well established principle in common law that the majority shareholders have a
right to ratify the conduct of the directors, even where they may have acted without
authority or irregularly. The Act recognizes this principle by providing that a purported
exercise of a power vested in the shareholders or any other person by a director or the
board of directors may be ratified or approved by the shareholders or that person in any
other manner in which the power may be exercised.

Ratification requires certain formalities. The Act specifies that it should be done in the
same manner in which the power should have been exercised. Thus, if the exercise of the
power required a special resolution in the first place, ratification would require a special
resolution. When the purported exercise of power is ratified, it is deemed a proper and
valid exercise of that power from the time it was initially exercised. There are also other
inherent principles that would govern proper ratification of an irregular act by directors.
Accordingly, ratification requires full and frank disclosure of the facts; the conduct
sought to be ratified must be ratifiable; ratification will have no effect on a coincident

57
Section 223.

22
private wrong, as for example an act which amounts to oppression; it must also be arms
length; and wrongdoers may not ratify their own irregular conduct.

This provision however is subject to an important qualification aimed at the protection of

minority shareholder rights. Accordingly, the ratification or approval under this section
does not prevent a court from exercising a power which might, apart from the ratification
or approval, be exercised in relation to the action of the board or director.59 Hence a court
might intervene where it is of the opinion that the ratification or approval would be
unfair, or where the exercise of the power by the director is liable to be restrained on the
basis that it amounts to a contravention of the provisions of the Act or the articles. A
court might also consider whether ratification would be unfair, when the possibility of
ratification is raised as a ground for not granting leave in a derivative action.

MINORITY BUY- OUTS

Companies generally operate on the basis of majority rule. Dissenting minority
shareholders are free to sell their shares and exit the company. However, this is often not
feasible, especially in unquoted companies, because of the lack of liquidity for such
shares. The Act seeks to strike a balance by providing the minority with specific
protections in the form of minority buy - out provisions.

The essence of the minority buy out principle is that when a company seeks to alter its
articles by imposing or removing a restriction on the business activities it can engage in;
or approves a major transaction; or approves an amalgamation under section 241, a
shareholder who votes against the resolution, or does not sign it, if it is sought to be
passed under section 144, can require the company to purchase his shares.60 Similarly,
when a company seeks to take action that will affect rights attached to shares,61 the
approval of each interest group as provided for in section 100 of the Act must be obtained
by a special resolution.62 Any shareholder within the interest group who votes against the
action, or does not sign the resolution sought to be passed under section 144, shall be
entitled to require the company to purchase his shares.63

The Act provides clear procedures that have to be followed by the board in the event that
a shareholder decides to exercise these rights. These cover the valuation of the price at
which the shares have to be purchased, methods of valuation, and options available to the
board when it is unable to comply with the provisions.

GENERAL CONCLUSIONS

59
Section 238.
60
Section 93.
61
These include rights, privileges, limitations and conditions attached to a share under the Act or the
articles including voting and distribution rights, pre-emption rights under section 53 of the Act, rights in
relation to procedure for amendment or alteration of Articles or a right to the non-amendment or alteration
of the Articles.
62
Section 99.
63
Section 100.

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The Companies Act No. 7 of 2007 marks a significant milestone in the development of
company law in Sri Lanka. Many of its features are improvements to what existed
previously. This is particularly true in respect of what has been introduced in relation to
the treatment of capital, directors duties and stakeholders rights. However, at the same
time there are certain features in the law that could be cause for concern and therefore
would deserve further examination. For instance:

• The law has, by design or by inadvertence, failed to recognize some essential

practices that were adopted by companies. A sound example of this is the treatment of
issuing bonus shares. Even though it is clear that the intent of those drafting the law
was not to exclude the possibility of issuing bonus shares, an inadvertent exclusion of
a provision that exists in corresponding laws to empower and facilitate companies in
issuing bonus shares has made it impossible to make such issues without exposure to
legal risks.
• The Act has imposed several responsibilities on directors which appear onerous in the
context of the economic climate in Sri Lanka. For instance, section 219 and 220 of
the Act which are discussed above, require directors to resolve whether or not to
liquidate companies when they are faced with solvency issues. Though these
requirements are laudable in that they ensure good governance and protection of
stakeholders, widespread concerns have been expressed that boards of a large number
of companies in Sri Lanka may have to resolve to liquidate companies under the
present circumstances. Had our law provided efficient restructuring processes, such a
situation could have been beneficially managed. However, the absence of such
mechanisms, and the dearth of a pool of qualified persons to perform functions as
directors appears to make this requirement unnecessarily burdensome on the
corporate sector.
• A further problem that will arise in the operation of the Act is that the Sinhala version
of the Act, which takes precedence, has inconsistencies with the English version. This
is a practical issue and reportedly, several inconsistencies have already been detected.
There is some uncertainty on how such inconsistencies will be handled in the event
they come up for resolution before a judicial forum, and they could be a source of
problems.

These issues will have to be recognized, acknowledged and addressed appropriately.

Certain measures would necessarily have to be in the form of amendments to the Act.
Additionally, several measures will be required to harmonize the various regulations,
such as the rules of the Stock Exchange and the Central Bank, with the provisions of the
Act. Unless these measures are taken without delay, the full benefit of the Act will not be
realized.

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