Capital reconstruction and schemes of arrangement

A capital reconstruction is what a company does when the alternative is closing down. Every investor must give something up, but each must be left better off than they would be on liquidation. This topic explains how a reconstruction scheme is designed, how each party’s position is compared before and after, and how the approval process works under the Companies and Allied Matters Act 2020 (CAMA 2020). A full worked case follows.

What a capital reconstruction is

The term applies when a company is in severe financial difficulty and must rebuild its statement of financial position. It is usually an alternative to liquidation. The assets may be worth less than the liabilities, so the company cannot pay its debts as they fall due. It must then agree with debenture holders and other creditors how their claims will be treated.

To return to profit, it often needs new capital from existing shareholders. With accumulated losses on the books, new shares are unattractive, so the share capital is written down to remove the losses and make earlier dividends more likely.

The benchmark: what each party gets on liquidation

Because liquidation is the alternative, the amount each party would receive on liquidation sets the standard for the scheme. A liquidator sells the assets as advantageously as possible and pays in this order:

1. creditors with a fixed charge, from the proceeds of the assets charged, with any deficiency ranking as unsecured;
2. the costs of liquidation;
3. preferential creditors, whose categories and limits are set by law, such as certain taxes and employees’ wages;
4. creditors with a floating charge;
5. unsecured creditors, including any unsecured balance from the earlier groups; and
6. shareholders, according to the articles. Preference shares are normally repaid before ordinary shares.

If a group cannot be paid in full, its members share what is available in proportion to their claims: the amount available divided by the total due to the group.

Designing the scheme

The aim is a profitable going concern. In some cases the difficulties are so severe that no scheme can achieve it. Where the company can operate profitably, a scheme may have a good chance of success if it relieves the burden of immediate debt and, usually, raises new finance, often by a new issue of shares.

A scheme that changes the rights of creditors and shareholders needs the votes of the required majority and the sanction of the court. Under CAMA 2020, an arrangement covers any change in the rights or liabilities of members, debenture holders or creditors, or any class of them (section 710).

The scheme is considered at court-ordered meetings of each class, and approval needs a majority representing at least 75% in value of those present and voting (section 715). The court then sanctions it, and it binds all members of the class (sections 715 to 717). To have any chance, the scheme must:

• give each interested party at least as much as on liquidation;
• be fair and equitable, so that no class is favoured at the expense of another; and
• be understood and accepted as fair by those affected.

In practice a reduction of capital and a reconstruction are combined in one scheme to write off accumulated losses or write assets down to realisable value.

Evaluating a scheme

Evaluate the scheme as a whole, because relative rights change. Participants have two kinds of right: to repayment of capital, and to share in income. Set out each party’s interest before and after, then compare outcomes in three cases: liquidation immediately after the scheme, earnings as expected and earnings higher than expected.

Worked case: Tadex Plc

Step 1: the capital reduction required

Step 2: the liquidation position

Premises of 1,800 go to the debenture holders. The other assets give 3,800 + 1,000 + 1,500 + 2,850 = 9,150. After liquidation costs of 590, 8,560 is left for unsecured claims of 9,200: the bank 6,000, the unsecured debenture balance 1,200 (capital 2,500 plus interest 500, less 1,800) and payables 2,000. Each receives 8,560 ÷ 9,200 = 93 kobo in the naira. The bank gets 5,580, the debenture holders 1,800 + 1,116 = about 2,916 (shown as 2,920), payables 1,860 and both classes of shareholders nothing. Everyone loses on liquidation, so all have a reason to agree.

Step 3: the scheme

After the scheme there are 4,160,000 shares of 50 kobo, held one-half by old ordinary holders, one-quarter by old preference holders and one-quarter by old debenture holders.

Step 4: the new statement of financial position

Land and buildings 5,600 plus plant 1,000 gives 6,600. Current assets are inventories 1,500, receivables 2,850 and cash 2,000, total 6,350. Current liabilities are the overdraft 6,000, one year of debenture interest 250, payables 2,000 and scheme costs 120, total 8,370, so net current liabilities are 2,020. Less the 15% debentures of 2,500, net assets are 2,080, which equals share capital of 4,160,000 shares at 50 kobo.

The poor current ratio comes from showing the overdraft as current, though the bank has agreed to keep it for the medium term.

Step 5: comparing the parties

Liquidation immediately after the scheme. The premises realise 5,600, less debentures of 2,750, leaving 2,850. Other assets give 5,350, and cash is 2,000 less 120, so 1,880. The total is 10,080, less liquidation costs of 590 gives 9,490. The bank takes 6,000 under its floating charge and payables 2,000, leaving 1,490. This goes one-quarter each to old debenture and preference holders and one-half to old ordinary holders: 372, 372 and 746.

Earnings. With earnings of 600, debenture interest takes 15% of 2,500, which is 375. The balance of 225 is shared one-quarter, one-quarter and one-half: 56.25, 56.25 and 112.5. With earnings of 1,000, the balance of 625 gives 156.25, 156.25 and 312.5.

Conclusion

The bank and the payables recover more on liquidation after the scheme than before it, because the bank’s debt is now secured and the company has new cash. The debenture holders invest a further 500. Their return on 3,420 (2,920 plus 500) is 12.6% at earnings of 600 and 15.5% at earnings of 1,000, with better security and a quarter of the shares.

Preference and ordinary shareholders would not recover their new money on an immediate liquidation, but their yield is high at expected earnings. On 500 invested, the preference holders earn 11.25% at 600 and 31.25% at 1,000. The ordinary holders earn the same percentages on their 1,000. If every class votes for the scheme and the court sanctions it, it becomes effective when the order is lodged with the Corporate Affairs Commission. If agreement cannot be reached, the company will be liquidated.

Why each party agrees

A smaller fairness test

1. Creditors on liquidation.
   400,000 ÷ 800,000 = 50 kobo in the naira.
2. Creditors under the scheme.
   480,000 ÷ 800,000 = 60 kobo, which is 20% more than liquidation would give.
   Their money arrives over two years, so they bear some risk and may ask for security.
3. Shareholders. They receive nothing on liquidation, so putting in ₦100,000 to keep the company is a reasonable bet if profits can cover the payments.
4. Conclusion. Each class is better off than on liquidation, and the sacrifice is shared fairly, so the scheme should meet the test. The next question is whether the business can generate enough cash to keep its promises.

Presenting the scheme in a report

In an exam answer, set out the position in a clear sequence. State the background and the problem. Show the liquidation position and the amount each party would receive. Describe the proposals, class by class, with the effect on share capital and the revised statement of financial position in an appendix. Compare each party before and after.

Say what could go wrong, then recommend whether the scheme should go ahead, and on what conditions. Show the workings in appendices and keep the key figures and the reasoning in the body.

Internal or external reconstruction?

Internal reconstruction is the usual choice, because the company continues with its contracts, licences and trading name. External reconstruction is considered when the old company carries liabilities or legal problems that a new company can leave behind, or when the business is to be moved into a different structure. It costs more in effort, because assets and liabilities must be transferred.

In either case the same test applies: each party must be better off than on liquidation, and the business must be able to make a profit afterwards.

Risks and conditions for success

• Viability. A scheme cannot rescue a business that cannot make a profit. Test the earnings forecast and its assumptions.
• Cash. New money must cover the immediate shortfall and the costs of the scheme.
• Votes. One dissenting class that does not reach 75% in value can stop the scheme, so the terms must be attractive to each class.
• Court and creditors. The court looks for fairness, and creditors whose rights are affected may object.
• Tax and legal effects. Changes such as replacing shares with loan stock can change the tax position and the gearing, so they should be reviewed before the proposal is final.

These points also give you a ready structure for the “evaluate the proposal” type of requirement, because they show how a good answer weighs the risks as well as the benefits.

What to include in an exam answer

• The liquidation position first, with each party\u2019s amount in naira.
• The capital reduction needed and what it is made of.
• The scheme for each class, with a reason for each term.
• A revised statement of financial position, noting any items that look odd, such as an overdraft shown as current.
• A table comparing every party before and after.
• A conclusion on whether the scheme is fair and likely to be approved, with the risks.

If a class refuses

A scheme can fail if one class does not reach the required majority. The usual response is to improve the offer to that class, for example with a higher share of the new equity, better security or a faster repayment. Any improvement must be paid for by another class or by new money, so test the new terms against the liquidation position again.

If no acceptable terms can be found, the company will be liquidated. Every party receives its liquidation amount, which in the Tadex case is far less than the scheme gives.

Common mistakes

• Designing the scheme before working out each party’s liquidation position.
• Offering any party less than liquidation would give, so the scheme cannot succeed.
• Forgetting that a fixed charge covers only the charged asset, and that any deficiency ranks as unsecured.
• Reducing creditors’ rights while leaving shareholders untouched.
• Leaving out the new money introduced when working out each investor’s return.
• Omitting the approval route: class meetings, a 75% in value majority and court sanction.

Quick revision

• Reconstruction is the alternative to liquidation. It can be internal or external.
• Liquidation order: fixed charge, costs, preferential, floating charge, unsecured, shareholders.
• Each party must get at least its liquidation amount, and the scheme must be fair and equitable.
• Compare before and after on liquidation and on expected earnings.
• Approval: class meetings, 75% in value, court sanction (CAMA 2020, ss. 710 to 717).

Practice questions

These are original questions in the style of the Institute of Chartered Accountants of Nigeria exam. Try each one before you open the answer.

Model answer

The next topic covers business analysis and the strategic tools of the Case Study.

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