Capital Reduction Of A Company, Why Does It Happen And What Actually Goes On

Capital reduction is the process of decreasing a company’s shareholder equity through share cancellations and share repurchases. The reduction of capital is done by companies for numerous reasons, including increasing shareholder value and producing a more efficient capital structure. After a capital reduction, the number of shares in the company will decrease by the reduction amount.

The Commercial justification for reduction of capital are many and varied. A company may wish to pay off a class of preferential shareholders and substitute debt as a source of fund, especially if the prevailing interest rate is below the the dividend payable on the preference shares. A company may write off accumulated losses by reducing the nominal value of its shares – this might be necessary if the shares were trading below par and a rights issue was contemplated. A company may also with to return assets that it could not use so as not to dilute its earning figures.

It may be of commercial sense at certain circumstances for shareholders of a company to attempt such steps.

One must make clear distinction between return of assets and return of shares.

In relation to return of shares (which is the subject matter for discussion here), a company has no power to refund to its members the money that they paid for their shares. Once a company has received money in payment for its shares, it cannot refund that money without the court’s leave to reduce capital.

A company cannot convert equity capital into a loan and then purport to repay it.

The general rule is that a company cannot call for capital reduction except with the sanction of the court governed by sec 73 of the Company’s Act (“the Act”).

The act provides that a company may reduce share capital in the following way:

(a) return of money to the company’s members, for example by refund of monies subscribed for shares to the shareholders; and by surrender of shares to the company (unless the company is in a position to forfeit such shares) and by sale of the company’s capital assets and division of the proceed among members.

(b) return of assets to the company’s member, for example distribution of shares owned by the company; or leasing of substantially all its property to its members without payment. The test is whether the company has divested itself of part of its undertaking in favor of its members otherwise than in the course of a bona fide transaction entered into as a matter of contract.

(c) reduction or extinction of a member’s liability to pay the amount unpaid on his shares.

(d) The reduction of the capital yardstick in the company’s account, viz the authorized (or nominal) capital, the share premium account and the capital redemption reserve.

The mode of reducing can be accomplished by canceling shares or reducing the nominal value. For example, a share with nominal value of RM 1 can be reduced to RM 0.50, it can extinguish the unpaid capital either by reducing the nominal value of the shares to RM 0.50 or by canceling one out of every two shares. The court is not concerned which way the shareholders/members decide to take.

The Act also states the following types of reduction of capital as exempted from s64(1) of the Act:

(a) the cancellation of shares that have not been taken up or which have been forfeited

(b) the application of the share premium account in writing off the preliminary expenses of the company or the expenses of the share issue; and

(c) the application of the share premium account providing for the premium payable on redemption of redeemable preference shares; and

(d) the cancellation of shares consequent on a purchase of those shares by the company by virtue of an order of the court unders 181 of the act. (oppression)

It is important to note that the court is not primarily concerned with the business aspects of the capital reduction. The court only has a two fold function – to consider whether the creditors (present and future) would be prejudiced and to ensure that the reduction is fair among the members inter se. The court should also consider the public interest.

Before confirming a reduction of capital, the courts must be satisfied that with respect to every creditor who is entitled to object either his consent to the reduction has been obtained or his claim has been discharged or secured.

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