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THE UTILITY OF CAPITAL REDUCTION AS A MEANS OF MITIGATING FINANCIAL DISTRESS

Capital reduction is the process by which a company’s shareholder equity is reduced through mechanisms such as share cancellations and share buybacks and may be applied towards providing a more efficient capital structure  and increasing shareholder value.

In the past three years, the nation has witnessed financial distress among powerhouse companies such as Kenya Airways, Nakumatt and Deacons. Financial distress is common where a company is unable to meet its financial obligations when they fall due or rather where a company’s liabilities outweigh its assets. In the wake of such a wave of financial hardship, it is fundamental for companies to explore a number of mechanisms to deal with the challenge at the grassroot level and at the early stages of such distress.

This paper interrogates capital reduction as a means of internally reorganizing the financial structure of a company in order to mitigate its losses and bring it back to a position of profitability. Capital reduction functions in a way that the various stakeholders of a company such as its ordinary and preferential shareholders, and creditors sacrifice part of their claims in the company in order to write off its accumulated losses and in this way mitigate financial distress. This mechanism is applied where a company has more equity and debt capital than its assets are worth.

The Legal Procedure of Capital Reduction

For a scheme of capital reduction to be enforceable it must be permitted by the Articles of Association of the Company.

The directors of a company may make a proposal to the company and to its creditors pursuant to section 625 of the Insolvency Act to effect a scheme of capital reduction to deal with recurrent losses that have been made in a company as opposed to liquidating it.

The key steps towards effecting a scheme of capital reduction entail the following:

  1. The company passes a special resolution to reduce its share capital. This requirement was further buttressed in the land mark case of Re Ransomes Plc [1999] 2 BCLC 591, CA where the Court approved a scheme of capital reduction because it was supported by the vast of the majority of the shareholders despite there being short notice of the meeting where the resolution was passed;
  2. An application is then made to the Court for an order confirming the reduction;
  3. Creditors of the company are entitled to object to the capital reduction;
  4. The creditors’ claims against the company may however be secured by making provisions for the amount of the debt;
  5. The Court makes the order confirming the reduction of capital on such terms and conditions as it considers appropriate but shall not do so until it is satisfied that the claims of creditors entitled to object to the capital reduction have been satisfied or secured or that the consent of the creditors have been obtained;
  6. The Court may direct that the company publishes a notice to the public indicating the reasons for the reduction; and
  7. The Company is then required to register the Court Order and Statement of Capital as amended with the Registrar of Companies.

The resolution reducing the Company’s share capital takes effect once the order and statement have been registered.

It is noteworthy that private companies need not obtain the courts consent when it comes to capital reduction. However, they are required to support the resolution for capital reduction and the amended statement of capital with a solvency statement when registering the capital reduction with the Registrar of Companies.

The solvency statement is drafted by the directors and states that in the event that the company were to commence liquidation proceedings within 12 months of the date of the statement, the company shall be able to satisfy its financial obligations within the 12 months.

However, whether the court sanction procedure or solvency statement procedure as described above is followed in capital reduction, it is fundamental for a company to engage the services of a certified accountant who shall be in charge of determining the accumulated losses of the company and developing an appropriate scheme of capital reduction that shall bring the company’s financials back to a position of profitability.

Advantage of Capital Reduction

Capital Reduction provides a mechanism to rehabilitate a company’s financial position in the short run without necessarily having to liquidate it.

Unlike other external reconstruction mechanisms such as mergers and acquisitions it enables a company to retain its corporate identity even in the face of financial hardship.

Capital Reduction also enables a company to deal with financial distress without causing a fundamental change in its organizational structure as the management and employees of the company remain the same.

Accumulated losses may prevent a company from paying out dividends to its shareholders and therefore capital reduction enables the company to write off these accumulated losses leading to an increase in its reserves and thus facilitate payment of dividends from reserves.

The Limitation of Capital Reduction

In the case of public companies, it is mandatory for the company to obtain the court’s consent before effecting a scheme of capital reduction which has the advantage of safeguarding the creditor’s interests however such litigation may be lengthy rendering capital reduction a time-consuming process.

Conclusion

From the foregoing, capital reduction is a means of internal reconstruction that enables companies to transform their financial position without necessarily transferring their assets or changing their organizational structure. Corporate entities are therefore encouraged to consider how viable this option may be in mitigating financial hardship as opposed to taking drastic measures such as liquidation. However, capital reduction can only off-set accumulated losses in the short-run and may not be a permanent solution to a company’s financial challenges. It is therefore important for companies to determine if there are other factors leading to accumulated losses other than overcapitalization, as the cause of financial loss plays a big role in determining the mode(s) of reconstruction to be applied.

If you have any query regarding the same, please do not hesitate to contact Faith Mwaka or  Ambrose Waigwa at faith@wamaeallen.com or ambrose@wamaeallen.com. Note that this alert is meant for general information only and should not be relied upon without seeking specific subject matter legal advice.

Associate

Ambrose is a civil and commercial litigator who has keen interest in commercial law, recoveries litigation, labour and employment disputes, banking law, tax law, company law, public policy and legislative development

Associate

Faith Mwaka is a transactional advocate specializing in Real Estate and Securitization, Banking and Finance

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