Reduction of Capital

Reduction of Capital

For any company, a capital reorganization issue is a process by which restructuring takes place and surplus cash is returned to shareholders. The other diagonally opposite reasons for reduction of capital is that there is no cash, in fact, capital is lost. The need of reducing capital may arise in various circumstances, for example, accumulated business losses, assets of reduced or doubtful value. As a result, the original capital may either have become lost or a company may find that it has more resources that it can profitably employ. So, in either of these cases, the need will arise to adjust capital and assets.

The structure varies from company to company as some may decide to replace existing ordinary shares with a different class of shares. The capital reorganization process takes place to reduce the number of ordinary shares in circulation and provide a mechanism that makes capital payment to the shareholders. The new share price may be different for the old share price.

If the capital of the company is reduced, it results in changes its memorandum by reducing the amount of its share capital and shares accordingly. If the company has arrears in repayment of deposits or interest payments, reduction of capital cannot be made by the company.

Reasons for reduction of capital

It is a sensitive issue and the legal aspects must be handled carefully

The requirement to reduce capital may arise because of many factors like to distribute assets to shareholders, pare off debt, make up for trading losses, capital expenses, etc. Many a times companies may have more capital resources and reserves than they can employ. Also, when the company is making losses, the financial position does not present a true and fair view of the company. The assets are overvalued and the balance sheet consists of fictitious assets with debit balance in profit and loss account. In order to reduction of capital will write-off that portion of capital which is already lost and will make the balance sheet look healthy.

So, reconstruction in which the once again reorganized by reevaluation assets and liabilities and writing off the losses by reducing the paid up of shares. Such a process is called internal reconstruction which is carried out without liquidating the company. It is an agreement to pare losses by creditors and shareholders.

Moreover, external reconstruction, which is totally different from internal reconstruction, can also take place because of the following reason:

  1. To increase or to create distributable reserves to enable future dividends to be paid to shareholders
  2. To return surplus capital to shareholders
  3. To facilitate a share buyback or redemption of shares
  4. As a part of a scheme of arrangement

How to reduce capital

The share capital of a company is the only security on which creditors rely. So, any reduction of share capital diminishes the fund out of which they are to be paid. As a result, companies with shares are not allowed to reduce the capital frequently. However, there may be genuine reason to reduce capital. The entity applying for reduction of capital will either be a company limited by shares or a company limited by guarantee but having share capital. The company can reduce capital by employing one of the following methods:

  1. Reduce the liability of its shares in respect of the share capital not paid-up
  2. Cancel any paid up share capital which is lost or is unrepresented by available assets
  3. Pay off any paid up share capital which is in excess

Managing capital reorganisation

During the times of managing capital reorgansiation issues, investors are told about the ratio of the old to new share, or the number of new shares cancelled or received for each class of shares. In cases where multiple classes of shares are received, the value of each class of share on the date of the capital reorganization is required to share out cost between the shares. Since reduction of capital is a very sensitive issue, the company has to get approval by the Tribunal on the application made. The tribunal will give notice to every application made for reduction of capital to the Central government, Registrar and to the Securities and Exchange Board of India in case of listed companies.

Notices will also be given to all the creditors of the company. In case no remark is made by these institutions and creditors within three months, then it will be presumed that they have no objection to the reduction of capital. The order of confirmation of the reduction of share capital by the tribunal will have to be published by the company. If the company fails to comply with the provisions relating to publication of order, it shall be punishable with fine which shall not be less than Rs 5 lac. Also, the company will deliver a certified copy of the Tribunal mentioning the amount of share capital, the number of shares into which it is to be divided and the amount of each share.

Reduction of capital without tribunal’s sanction

Reduction of capital can take place without the sanction of the tribunal/court in case of buy back of shares. In case of forfeiture of shares, a company may if authorized by its articles forfeit shares for non-payment of calls by the shareholders. Such proceedings will amount to reduction of capital but the act does not need court sanction for this purpose.

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