Legal Definitions - restricted surplus

A restricted surplus refers to a portion of a company's accumulated profits (its surplus) that cannot be freely distributed to shareholders as dividends or used for certain other purposes. These limitations are typically imposed by law, contractual agreements (such as loan covenants), or the company's own board of directors. The purpose of restricting a surplus is often to protect creditors, ensure the company's financial stability, or earmark funds for specific future projects.

Here are some examples illustrating a restricted surplus:

• Legal Requirement for Creditor Protection: A state's corporate law might mandate that companies maintain a certain level of capital as a "legal reserve" to ensure they can meet their obligations to creditors. For instance, a manufacturing company has accumulated significant profits over several years. The state law requires that a specific amount of these profits, say $5 million, must be held as a legal reserve and cannot be paid out as dividends to shareholders. This $5 million portion of the company's surplus is a restricted surplus because its use is legally limited to protect creditors.

• Contractual Loan Covenants: When a company takes out a large loan, the loan agreement often includes covenants that restrict how the company can use its profits. Imagine a real estate development firm secures a substantial bank loan to finance a new project. The loan agreement stipulates that the firm cannot distribute more than 15% of its annual net income as dividends to shareholders until the loan is fully repaid. Any accumulated profits beyond that 15% that would otherwise be available for distribution but are held back due to this loan covenant constitute a restricted surplus. The restriction is contractual, preventing the free use of those funds for shareholder payouts.

• Board-Designated Funds for Specific Projects: A company's board of directors may decide to set aside a portion of its profits for a specific, long-term strategic investment. For example, the board of a software company passes a resolution to earmark $20 million of its accumulated profits specifically for a major research and development initiative to create a new product line over the next three years. While these funds are part of the company's overall surplus, the board's resolution restricts their use solely for this capital project. They cannot be used for general operating expenses or distributed as dividends, making this $20 million a restricted surplus due to an internal corporate decision for a specific future purpose.