3 Things You Need To Know About the Process of Share Capital Reduction
12 minute read
Share capital reduction is the term used for the process of decreasing a company’s shareholder equity. Another term for this concept is share buybacks, and it is done through share cancellations and share repurchases.
Companies usually want to reduce share capital due to various changes in their business strategy. It often happens that companies have more issued share capital than what is required for its optimal functioning and growth, but there are many more reasons why companies would look to reduce share capital.
If you are an entrepreneur familiar with the Hong Kong business current, your company may take advantage of the court-free capital process to conduct capital reduction and thus optimize excess capital.
How Share Capital Reduction Process Works
Following a capital reduction, the number of shares in the company decreases by the set reduction amount. Keep in mind that the company’s market capitalization will not change as a result of such a move. On the other hand, the float, or the number of shares outstanding and available to trade, shall be reduced.
When there is a decline in a company’s operating profits or a revenue loss that cannot be recovered from a company’s expected earnings, the act of capital reduction may be enacted. Some capital reductions involve shareholders that receive cash payments for shares canceled. However, in most scenarios, there is minimal impact on shareholders.
For a company that wishes to reduce its share capital, it has to rely on a set of predefined steps.
- In most jurisdictions, first, a notice has to be sent out to creditors of the resolution of the capital reduction.
- Then, the company has to submit an application for entry of the reduction of share capital no earlier than three months after the publication of the initial notice.
- Share capital is to be paid to shareholders no earlier than three months following the entry of reduction in the commercial register.
Hong Kong Companies Ordinance
When it comes to Hong Kong, the court-free reduction process is stipulated in the new Companies Ordinance (Cap. 622), which has introduced a court-free process for the reduction of capital of companies.
The court-free process requires directors to provide a solvency statement to reduce the company’s capital. That is a faster and cheaper way compared to the court-sanctioned process where the company is clearly solvent.
The governing provisions for the court free process for reduction of share capital are stipulated in sections 215-225 of the Companies Ordinance.
The types of reduction include a company:
- Reducing the liability on any shares in respect of share capital not paid-up
- Canceling any paid-up share capital that is unrepresented by available assets
- Repaying any paid-up share capital which is in excess of the wants of the company
The reduction of share capital is subject to any stipulations in the company’s articles that forbid or restrict a reduction. Should the company’s articles have such a rule, it is required for the company to change its articles prior to the reduction.
Keep in mind, too, that if the reduction results in its members holding only redeemable shares, the company cannot reduce its capital.
3 Things You Need To Know About Share Capital Reduction
Let’s go through the three key considerations about capital reduction and why this process is easier in Hong Kong compared to most other places.
1. It’s easier in Hong Kong
In most jurisdictions around the world, share capital reduction has to involve courts and often lengthy procedures. It is never possible to determine exactly when there will be a need for capital reduction owing to changes in the company’s structure and financial standing.
These are just some of the reasons why a company may need to reduce capital:
- Giving back excess capital to shareholders
- Canceling or reduce paid-up capital that is no longer needed
- Creating reserves arising from capital reduction
Hong Kong authorities realized how burdensome the whole process can be and they decided to make a change in 2014, when the Hong Kong government introduced Cap 622 of the Companies Ordinance of Hong Kong SAR (“CO”), to facilitate ease of conducting business.
This action was taken to better align the law with international standards and provide greater flexibility to businesses in structuring their share capital. The reduction of share capital under the old CO was only allowed if it was approved by the shareholders through a special resolution, and if the reduction of share capital is subsequently confirmed by the court.
The new Companies Ordinance stipulates that a company can undergo an alternative court-free process to reduce its capital, subject to passing the uniform solvency test. This court-free process simplifies the procedures for reducing the company’s excess capital. This method is not only faster, but it’s also cheaper than the more technical court-based process.
It is applicable to companies that are clearly solvent. Additionally, the directors are in a good position to ascertain the company’s solvency and how it will perform in the future.
The new regime has no requirements for attaching an auditors’ report to the solvency statement. Thanks to this, companies have greater flexibility in undertaking corporate restructuring exercises.
In addition, the new regime circumvents the obstacles for capital reduction, with the court exercising its discretion and refusing the proposed reduction.
2. Uniform solvency test
A uniform solvency test was designed for the new Companies Ordinance. This test is a prerequisite for all companies that wish to reduce their share capital relying on the court-free procedures. It also applies to situations when a company wants to buy back its own shares and provide financial assistance to acquire its own shares.
To pass the solvency test, these procedures have to be followed:
- Immediately following the transaction, there must be no ground on which the company could be found unable to pay its debts.
- The company has to be able to pay its debts as they become due during the period of 12 months immediately following the transaction, or if the company is about to start the process of winding up within 12 months after the date of the transaction, to pay its debts in full within 12 months after the start of its winding up.
A solvency statement has to be devised and signed by directors who have formed the mutual opinion that the company meets the solvency test requirements.
A director must check the company’s state of affairs and prospects and consider all liabilities (including contingent and prospective) of the company in forming his opinion. Also, a director who makes a solvency statement with no reasonable grounds for the opinion expressed in it is committing a criminal offence.
There is no requirement for an auditors’ report, since the government deems that auditors would not be in a better position than the directors to ascertain the company’s solvency.
To sum it up, the test is there to help a company better express details in a solvency statement. All directors need to sign it and certify it. All requirements have to be met, while falsely reporting that the requirements have been met can result in legal action.
3. Practical implications
Every director at a company should be aware of the importance of paying close attention to fulfilling all requirements before making the decision regarding the capital reduction.
Share capital reduction, in its nature, can be a bit complex and tedious. The extended use of the solvency test under the CO will increase a director’s exposure to potential liabilities, and this applies to both civil and criminal liabilities.
Directors need to consider the following issues if they want to make sure that the reduction of share capital is in the best interests of the company and the shareholders as a whole:
- Are there any particular reasons for keeping the current large amount of capital?
This refers to any special trading requirements for the local or foreign business of the company, any licensing requirements, agreements with trading partners, or any other historical reason.
- Is the company still required to comply with the mentioned requirements and maintain such a large amount of capital?
- How much capital does the company want to reduce and return back to the shareholders?
Now, even though an auditor’s statement is not required, it would be a good idea to consider having certified accountants assess the current financial state of the company and the impact of share capital reduction on the company.
The directors should also think about starting the process for reduction of share capital when audited financial statements are made available. This would help ensure the variation in the company’s financial status is minimal from the time of initiating the process and date of approval.
Keep in mind that, in some non-standard cases, a court-sanctioned process may be worth considering. For instance, there are cases where objections are anticipated from shareholders or where there are divided opinions regarding the solvency position of the company among directors.
Now, the business should be aware that any creditor or non-approving shareholder may (within five weeks after the special resolution is passed) apply to the court for cancellation of the resolution. Should this happen, the court will pass an order either confirming or canceling the resolution.
Moreover, there are scenarios when companies are looking for restructuring beyond share capital reduction, with a few other options based on the revised CO.
Businesses can also choose to execute restructuring through court-free amalgamation. Regardless of the options used for capital restructuring, it is important that the directors ensure they have taken due consideration when deciding to restructure.
Shareholders or creditors have to be provided with adequate information to approve the special resolution in the share capital reduction process.
It is a top priority for the directors to make sure that there is no prejudice and that creditors’ interests are not adversely affected. Also, the directors need to make sure that the capital restructuring is reasonable, and that all the shareholders and creditors are treated fairly and adequately.
Finally, the directors’ resolution approving the reduction of share capital should clearly lay down the factors that the directors have taken into account and the reasons for forming their opinion in the solvency statement.
The new regime truly helped to improve the whole share capital reduction process, and this court-free process should definitely be considered if you decide to reduce share capital.
However, even with the Hong Kong authorities having ensured that the process is smoother and more convenient, you need to keep these tips in mind before you make an action that could have serious consequences.
If you have questions about share capital reduction, contact Sleek and have our experts guide you.