Rationale for Capital Reconstruction
To eliminate 3 issues that prevent a distressed company from recovering
- Negative retained earnings
- Companies with accumulated losses are not allowed to pay dividends. One reason is that it prevents the shareholders from withdrawing money and leaving the debt holders high and dry.
- This discourages potential investors from investing in the company.
- The company will find it difficult to obtain debt financing as well.
- Distressed companies are cash strapped. Needing to pay interest puts burden on the company, and prevents it from committing necessary capital to turn around the business.
- The debt and interest also results in high gearing and low interest coverage ratios, which again prevents the company from obtaining additional debt financing.
- Same reasons as per debt, since preference shares are essentially debt.
Types of Entity Construction Schemes (accounting speak)
- Capital reduction
- Liquidation via a new company
Capital Reduction Scheme
This addresses the 1st point above. A capital reduction scheme essentially recognises the loss that the equity holders have incurred by adjusting equity reserve accounts. A company
- Resets any negative retained earnings account by offsetting it with equity reserve accounts (e.g. share premium account first, followed by share capital account)
- Writes off any unpaid share capital by reducing the value of its share capital and restating as fully paid shares.
- Writes off share capital not backed by available assets (e.g. reducing intangibles and share capital)
Since this would allow equity holders to pay themselves dividends again, court approval is typically required so as to take into account the interests of other stakeholders (e.g. debt holders).
This addresses the 2nd and 3rd points above. This involves the company
- Writing off overdue debt interest and restructuring debt to have lower interest and extended maturity
- Writing off cumulative preference shares dividend owed
- Writing off amounts owed to suppliers
- Issuing new shares (crediting equity reserves) to the previous debt holders, preference shares holders, suppliers for accepting to restructure the debts.
Essentially debt holders convert to being equity holders, possibly retaining a lower debt amount. This allows them to recover their funds through the company’s recovery, as opposed to not recovering their funds when the company collapses.
Liquidation via a New Company
- Selling assets to another company
- Using the proceeds to pay down remaining debts, and liquidating the business.
- Profit recognised is based on proceeds less carrying costs of remaining net assets.
- The buyer of the assets will still recognise Goodwill based on the fair value of the assets bought.