Lawrence Robert Dicksee.

Auditing: a practical manual for auditors online

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lution was passed by the directors that the profit derived from the
sale and repurchase of the bank's business in Brazil be treated as
profit to be carried to the Profit and Loss Account of the bank, and
dealt with accordingly. It was stated that the present proceedings
were of a friendly character, both parties being desirous of obtaining
the opinion of the Court.

Mr. Whitehome, Q.C., and Mr. S. Dickinson, in support of the
motion, submitted that to carry over the ;£205,ooo to a Profit and Loss
Account appeared to be ultra vires the company, as, according to the
authorities, Frames v. Bultfontein Mining Company (L.R. i, Ch. 1891,
140), Lee V. Neuchdiel Asphalte Company (L.R, 41, Ch.D. 1, per Lord
Justice Lopes, p. 26), a sum like the present, produced by the sale of
part of the undertaking of the company, and not by earnings, should
be treated as an accretion of capital to be placed to the Capital
Account, and it was also argued that, having regard to the statements
issued to the shareholders by the directors with regard to this par-
ticular fund, it was not competent for the directors to act on the



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REPORTS OF CASES. 565

Tesolution in question or carry the fund to the Profit and Loss
Account.

Mr. Byrne, Q.C., and Mr. Methold appeared for the company,

JUDGMENT.

Mr. Justice Chitty held that the ^205,000 was plainly profit on
capital, and not part of the capital itself, for that sum was the surplus
ascertained on the assets' side after the liabilities and capital were
placed on one side of the account and the assets on the other. Under
the articles of the company the directors were justified in carrying over
the ;^205,ooo to a Profit and Loss Account, and, having appropriated
to the Reserve Fund so much of the sum as they thought fit, they
could distribute the remainder as dividends after an ordinary meeting
called in pursuance of the articles had passed the requisite resolution.

{Acct, L.R., 1892, p. 56.)



The case of THE EDINBURGH UNITED BREWERIES, LIM.,

AND OTHERS v. JAMES A. MOLLESON (NICHOLSONS

TRUSTEE) AND ANOTHER.

(Decided in the Scottish Court of Appeal before the Lord President,
and Lords Adam, M'Laren, and Kinnear, on 17th March 1893.)

Held that a Contract of Sale of a Business cannot be upset on the ground that the
Accounts submitted for Inspection prior to Purchase turn out to be falser provided
the Sale was made bona fide and without Warranty.

In this action the Edinburgh United Breweries, Lim., and William
H. Dunn, 27 Bishopsgate Street, London, sued James A. Molleson,
C.A., Edinburgh, as trustee of David Nicholson, Parson's Green, for
the reduction of the sale of the Palace Brewery, on the ground that the
books had been falsified in order to show a larger profit than that
actually earned during the two years preceding the sale. Lord
Kyllachy assoilzied the defenders, with expenses, on the ground that
if there was a fraud the pursuer had opportunity of discovering it by
examination of the books. The pursuers reclaimed, and to-day the
Court, following Lord M'Laren, adhered to the judgment of the Lord
Ordinary, with expenses.

JUDGMENT.

Lord M'Laren, who gave the judgment of the Court, said the case
was peculiar in this respect, that while the action was laid on the
ground of fraudulent representations, no personal fault was
attributable to Mr. Molleson, who was known to be a gentleman of



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S^6 AUDITING.

high standing in his profession. The case against him was that he
employed Andrew Smith Geddes to keep the books of the brewery
while it was under his management as trustee ; that Geddes, for his
own purposes, falsified the books and the Balance Sheets; that Mr.
Dunn was induced to become the purchaser in reliance on the
apparent profits exhibited on the face of the books and Balance
Sheets, and was in that sense deceived by representations for which
it was said Mr. MoUeson was civilly responsible. So far as his Lordship
understood, Geddes had no motive to falsify the books beyond the
wish to please his employer and keep his situation by giving an aspect
of fictitious prosperity to the business. By the agreement of
November between Mr. MoUeson and Mr. Dunn the sum of ;^3,7oo
was to be paid down, and the balance of the price was to be paid on
31 si December, when the conveyance was granted. By the tenth
clause of that agreement it was provided that the arrangement pro-
ceeded upon the basis that the net profits from the brewery and wine
businesses during each of the two years 18S7 and 1S88 amounted to
/"3,750, or thereabout, upon an average ; and in the event of its being
ascertained that that was not the fact, this arrangement should be at
an end, and the second party (Mr. MoUeson) should be bound to repay
the sum of ;^3,7oo. The first party (Mr. Dunn), with the view of
verifying the amount of the profits for the two years, should be
entitled to have the books, accounts, and vouchers connected with
the businesses examined by an accountant named by him. The ques-
tion was whether Mr. MoUeson, as vendor, was affected by the fact
that false entries were made in the books by the clerk Geddes for
the purpose of bringing out an apparent profit in excess of the real
profit. The excess was stated at £ij2^o, but the exact sum was
immaterial to the present inquiry. It was a condition of the bargain
that the books had to be delivered to the purchaser for examination,
and his Lordship thought that condition was not fulfilled by deliver-
ing dishonest books. It was just the same as giving no books at all ;
and his Lordship had come to the conclusion that Mr. Dunn was not
barred by the loth article from challenging the sale on the ground of
fraudulent representations as to the profits of the business, because
he only agreed to take the risk of profits on the condition that books
containing a true record of the brewery transactions should be sub-
mitted to him for examination. But, while his Lordship held it to be
established that a fraud was committed inducing Mr. Dunn to enter
into the contract, it did not foUow that the pursuers, severally or col-
lectively, were in a position to enforce the claim of restitution. The
really important question was whether Mr. Dunn had a right to reduce
his contract of sale — such a right as he could communicate to the
United Breweries, to whom he had sold the brewery for ;^28,5oo, the



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REPORTS OF CASES. 567

price he paid to Mr. Mollescn being £2o,$oo. Mr. Dunn resold the
brewery at a profit, and he was not proposing to relinquish the profit
of ;^'8,ooo which came to him indirectly through the false impression
which the books produced on the minds of the purchasers from him.
On the discovery of the fraud which had been practised upon him, Mr.
Dunn was under no obligation to cancel the sale to the United
Breweries. He had sold to them in good faith and without warranty.
If Mr. Dunn proposed to repay the ;{,'8,ooo on the ground that he could
not conscientiously retain it^ and to assign his claim of restitution
against Mr. Molleson in order that the United Breweries might obtain
redress, he would have found in him (Lord M'Laren) a convinced
partisan of the duty of restitution. It would be no answer to him to
say that he had the means of recouping himself by holding the United
Breweries to their bargain. A purchaser in such a case was entitled
to say — *' I refuse to take a benefit which has been obtained by fraud :
and I will neither hold my purchaser to his engagements nor will I
submit to be bound by the deception which has been practised on
myself.*' His Lordship was not imputing any blame to Mr. Dunn, or
to the parties whom he represented, because they had not begun by
making restitution. He did not know that they had been asked to do
so. He only wished to put their case in a clear light. He understood
Mr. Dunn's position to be this — that he meant to keep the ;£8,ooo,
which he was enabled to make by the exhibition of forged books and
fraudulent Balance Sheets, and at the same time to try and cut down
his title to the subject of sale on the ground that the title was vitiated
by that very fraud. It was clear that, if Dunn were suing by himself
alone, it would be a conclusive answer to his claim that he had sold
the subjects at a price calculated on the erroneous value attributed
to the subjects, that he had not repaid the price to his sub-vendor,
and that he had, therefore, made a profit out of the fraud. The
circumstance that he had bought back the property, and was thus
enabled to offer restitution, would not, in his Lordship's judgment,
improve his position. Plainly Dunn could communicate no higher
right to the United Breweries than he himself possessed. The United
Breweries had no direct claim of aiiy kind either against Molleson or
against Dunn. Whatever right of action they might acquire through
Dunn, by being joined with him as pursuers, must be measured by
his right, and it followed that the action, considered as an action at
the instance of the United Breweries, must also fail.

Their Lordships concurred.

(Acct. 1893, p. 301.)



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568 AUDITING.

The case of VERNER v. THE GENERAL AND COMMERCIAL
INVESTMENT TRUST, LIM.

(Decided before Lords Justices Lindley, Kay, and Smith, in the
Court of Appeal, on 7th April 1894.)

Held that an I nj unction to restrain a Company from paying a proposed Dividend
out of current Profits on the ground that the Capital of the Company is not
intact, must be refused if the Company is solvent, and acting within its Articles.

This was an appeal from a decision of Mr. Justice Stirling. It raised
a very important question in company law — viz., whether, where there
has been a loss in the capital of a company through depreciation in
the value of its assets, the company is entitled to pay dividends out of
profits earned by means of its investments without first reducing its
capital so as to meet such depreciation. The action was brought by
William Henry Verner, on behalf of himself and all other stock-
holders of the defendant company other than the directors, against
the company and the directors. ' It came before the Court upon a
motion by the plaintiff asking that the defendants might be restrained
from declaring and from distributing among the members of the
company any dividend in respect of the financial year of the company
terminating on February 28 1894. The company was incorporated
on January 26 1S88, under a memorandum and articles of association,
with a capital of ;^6oo,ooo in 60,000 shares of ;^io each, all of which
had been issued and fully paid up in cash and converted into stock
of two classes —preferred and deferred. In addition to its original
share capital the company had borrowed ;^3oo,ooo on the security of
debenture stock, bearing interest at 4 per cent., and secured by a
floating charge upon all the assets of the company. There had thus
come to the hands of the company ;^9oo,ooo, which had been invested
in various securities authorised by the memorandum of association.
The present market value of such investments was only £(>SAi77^»
showing a depreciation of ;^24o,ooo. According to the evidence of the
plaintiff it appeared that " of such depreciation ;£^7S,ooo or thereabouts
represented the amount which there was no prospect of recovering
within any reasonable period of time." During the past year the
receipts of the company in respect of income derived from their
investments had exceeded the expenditure by upwards of ;^23,ooo.
The question for the Court upon the motion was whether, there being
a loss of capital to the amount of ;^75,ooo and an excess of profits
over expenditure of ;^'23,ooo, a dividend could lawfully be declared
and paid. The company was formed for the purpose of raising money
and investing the same in various investments mentioned in the memo-
randum of association, and one of the objects of the company was



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REPORTS OF CASES. 569

^* to receive the dividends, income, profits, bonuses, and advantages
of every description from time to time payable or receivable in respect
of the company's investments, and to apply the same respectively
according to the provisions of the articles of association, in force for
the time being." The articles provided : —(84) "Subject to the rights
of members holding share capital issued upon special conditions the
receipts of fhe company from the dividends, income, profits, bonuses,
and advantages payable or receivable in respect of the company's
investments shall be applicable as follows: — First, to the payment
of a dividend for the particular year at the rate of 5 per cent, per
annum on the preferred stock ; second, to the payment of such a
dividend on the deferred stock as the same shall suffice to pay, and
the trustees may, with the sanction of the company in general meet-
ing, declare a dividend to be paid to the members accordingly."
{85) " The trustees may, before recommending any dividend, set aside
out of the profits of the company such sum as they think proper as a
Reserve »Fund to meet contingencies, or for equalising dividends, or
ior any other purposes of the company ; and may from time to time
apply the whole or any part of such fund for any purposes of the
company." Mr. Justice Stirling, having regard to the nature of the
constitution of this company, held that there was no legal obligation
on the part of the company to make good the loss arising from the
diminution in the value of the investments before declaring a
•dividend, and he dismissed the action. The plaintiff appealed.

Mr. Graham Hastings, Q.C., and Mr. Kirby were for the appellant ;
Mr. Buckley, Q.C., and Mr. Eve were for the respondents.

The Court dismissed the appeal.

JUDGMENT.

Lord Justice Lindley delivered the judgment of himself and Lord
Justice A. L. Smith as follows : — The broad question raised by this
appeal is whether a limited company which has lost part of its capital
can lawfully declare or pay a dividend without first making good the
capital which has been lost. I have no doubt it can — that is to say,
there is no law which prevents it in all cases and under all circum-
stances. Such a proceeding may sometimes be very imprudent, but a
proceeding may be perfectly legal and may yet be opposed to sound
commercisd principles. We, however, have only to consider the
legality or illegality of what is complained of. As was pointed out in
Let V. Netuhdtel Asphalte Company (41 Ch.D. i), there are certain pro-
visions in the Companies Acts relating to the capital of limited com-
panies ; but no provisions whatever as to the payment of dividends or
the division of profits. Each company is left to make but its own



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570 AUDITING.

regulations as to such payment or division. The statutes do not even
expressly and in plain language prohibit a payment of dividend out
of capital. But the provisions as to capital, when carefully studied,
are wholly inconsistent with the return of capital to the shareholders,
whether in the shape of dividends or otherwise, except, of course, on
a winding-up, and there can, in my opinion, be no doubt that 'even if
a memorandum of associaticn contained a provision for paying divi-
dends out of a capital such provision would be invalid. The fact is
that the main condition of limited liability is that the capital of a.
limited company shall be applied for the purposes for which the com-
pany is formed, and .that to return the capital to the shareholders
either in the shape of dividend or otherwise is not such a purpose as
the Legislature contemplated. But there is a vast difference between
paying dividends out of capital and paying dividends out of other
money belonging to the company, and which is not part of the capital
mentioned in the company's memorandum of association. The capital
of a company is intended for use in some trade or business, and is
necessarily exposed to risk of loss. As explained in Lte v. Neuch&tet
Asphalte Company, the capital even of a limited company is not a debt
owing by it to its shareholders, and if the capital is lost the com-
pany is under no legal obligation either to make it good or, on that
ground only, to wind up its afiairs. If, therefore, the company has
any assets which are not its capital within the meaning of the
Companies Acts, there is no law which prohibits the division of such
assets amongst the shareholders. Further, it was decided in that
case, and, in 'my opinion, rightly decided, that a limited company
formed to purchase and work a wasting property, such as a leasehold
quarry, might lawfully declare and pay dividends out of the money
produced by working such wasting property without setting aside part
of that money to keep the capital up to its original amount. There
is no law which prevents a company from sinking its capital in the
purchase or production of a money-making property or undertaking,
and in dividing the money annually yielded by it without preserving
the capital sunk so as to be able to reproduce it intact eithet before
or after the winding-up of the company. A company may be formed
upon the principle that no dividends shall be declared unless the
capital is kept undiminished, or a company may contract with its
creditors to keep its capital or assets up to a given value. But in the
absence of some special article or contract there is no law to this
effect, and, in my opinion, for very good reasons. It would, in my
judgment, be most inexpedient to lay down a hard and fast rule which
would prevent a flourishing company either not in debt or well able
to pay its debts from paying dividends so long as its capital sunk in
creating the business was not represented by assets which would, if



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REPORTS OF CASES. 57 1

sold, reproduce in money the capital sunk. Even a sinking fund to
replace lost capital by degrees is not required by law. It is obvious-
that dividends cannot be paid out of capital which is lost : they can
only be paid out of money which exists and can be divided. More-
over, when it is said, and said truly, that dividends are not to be
paid out of capital, the; word " capital " means the money subscribed
pursuant to the memorandum of association, or what is represented
by that money. Accretions to that capital may be realised and turned
into money which may be divided amongst the shareholders, as was
decided in Lubbock v. British Bank of South America (1S92, 2 Ch. 199).
But, although there is nothing in the statutes requiring even a limited
company to keep up its capital, and there is no prohibition against
payment of dividends out of any other of the company's assets, it does
not follow that dividends may be lawfully paid out of other assets
regardless of the debts and liabilities of the company. A dividend
pre-supposes a profit in some shape, and to divide as dividend the
receipts, say, for a year, without deducting the expenses incurred
in that year in producing the receipts, would be as unjustifiable in
point of law as it would be reckless and blameworthy in the eyes of
business men. The same observation applies to payment of divi-
dends out of borrowed money. Further, if the income of any year
arises from a consumption in that year of what may be called circu-
lating * capital, the division of such income as dividend without,
replacing the capital consumed in producing it will be a payment of a
dividend out of capital within the meaning of the prohibition which
I have endeavoured to explain. It has been already said that divi-
dends pre-suppose profits of some sort, and this is unquestionably
true. But the word "profits" is by no means free from ambiguity.
The law is much more accurately expressed by saying that dividends
cannot be paid out of capital than by saying that they c^ only be
paid out of profits. The last expression leads to the inferences that
the capital must always be kept up and be represented by assets
which, if sold, would produce it ; and this is more than is required
by law. Perhaps the shortest way of expressing the distinction which
I am endeavouring to explain is to say that fixed capital may be sunk
and lost, and yet that the excess of current receipts over current pay-
ments may be divided, but that floating or circulating capital must be
kept up, as otherwise it will enter into and form part of such excess,
in which case to divide such excess without deducting the capital
which forms part of it will be contrary to law. The Companies Acts
do not require even limited companies to keep accounts, still less to
keep them in any particular form. The only enactment on the subject
is Section 26 of the Companies Act 1862, and Form D in the third
schedule, and these relate solely to the nominal capital and calls..



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572 AUDITING.

But, although this is so, yet, as a matter of business, accounts of
some sort must be kept, and in order to show what has been sub-
scribed by the shareholders and what has become of the money so
subscribed, and to show the results of the company's trading or
business, it is practically necessary to keep a Capital Account, and
what is called a Profit and Loss Account, and as a matter of business
these accounts ought to be kept as business men usually keep them.
Accordingly, we find provisions for keeping such accounts in Table
A in the Appendix to the Companies Act 1862 (see articles 78-82), and
in the articles of association of most, if not all, companies. But
there is no law which compels limited companies in all cases to
recoup losses shown by the Capital Account out of the receipts
shown in the Profit and Loss Account, although care must be
taken not to treat capital as if it were profit. This is in accordance
with Bolton v. Natal Land Company (1892, 2 Ch. 124), which is the
latest reported case on the subject. Further, it is obvious that capital
lost must not appear in the accounts as still existing intact ; the
accounts must show the truth and not be misleading or fraudulent.
The Acts of 1867 and of 1877 are in no way inconsistent with these
observations. They provide for the reduction of the nominal capital
mentioned in the memorandum of association. They do not render it
obligatory on a company which has lost some of its capital to reduce
the nominal amount mentioned in its memorandum. There are
advantages in doing so, and the Acts were passed to enable limited
companies to obtain these advantages, but there is nothing in these
Acts, any more than in the Act of 1862, which prevents a company
which has lost part of its capital from continuing to carry on business
and declaring and paying dividends. A law forbidding this may well
have been considered by the Legislature far too rigid, and in their
desire to check dishonest and reckless trading, Courts must be careful
not to put tighter fetters on companies than the Legislature has autho-
rised. It follows from what has been said above that the proposed
payment of dividend in this particular case cannot be restrained.
Mr. Justice Stirling has, in his judgment, examined the memorandum
and articles of association so fully that I do not think it necessary
to examine them again. It is plain there is nothing in them which
requires lost capital to be made good before dividends can be
declared. On the contrary, they are so framed as to authorise the
sinking of capital in the purchase of speculative stocks, funds, and
securities, and the payment of dividends out of whatever interest,
dividends, or other income such stocks, funds, and securities yield,
although some of them are hopelessly bad, and the capital sunk in
obtaining them is lost beyond recovery. There is no suggestion of
any improper juggling with the accounts, and ihere is no payment of



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REPORTS OF CASES. 573

dividend out of capital. There is no insolvency, and we have not to
deal with a petition to wind up. Some capital is lost, but that is all
that can be truly said, and that is not enough to justify such an
injunction as is sought. The appeal must be dismissed.

Lord Justice Kay gave judgment to the same effect.
{Times, 8 April 1894.)



The case of WILMER v. M'NAMARA & Co.

(Decided before Mr. Justice Stirling, in the Chancery Division,
on 26th April 1895.)

Held that a Company cannot be restrained from declaring a Dividend out of
current Pfofits, because no provision has been made for Depreciation of Fixed
Assets.

This was a motion on behalf of the ordinary shareholders of the



Online LibraryLawrence Robert DickseeAuditing: a practical manual for auditors → online text (page 45 of 70)