Corporate restructuring, capital reorganisation and capital reduction under CAMA 2020

When a company is losing money, short of cash or weighed down by losses carried in its books, a restructuring may be the only way to save it. Case Study requirements ask what should be done and what each investor would be asked to give up.

This topic explains what restructuring is, why it is needed, the three types of financial restructuring and how a capital reduction scheme is designed and approved under the Companies and Allied Matters Act 2020 (CAMA 2020).

What corporate restructuring is

To restructure is to give something a new structure. Corporate restructuring is the process of significantly changing a company’s business model, management team or financial structure to meet challenges and raise shareholders’ value. It may involve cutting or merging departments, or selling or merging the company with another. Its purpose is to improve efficiency and profitability and to secure long-term survival.

It is a response to significant problems, or to the threat of liquidation, or a way to turn the company in a new direction.

Shareholders or creditors may call for it when they fear the business is losing the value of their investment. Common triggers are loss of market share, falling margins, a weaker brand, failure to keep talented staff and major market changes that undermine the business model.

Successful restructuring depends on understanding four things: why the change is needed, what must change, how it will be achieved and what comes next, including a plan for the future.

In most turnarounds and insolvencies, both occur together. A company’s financial structure includes paid-up equity, preference shares, reserves and borrowings of every kind: long-term loans, debentures, bonds, overdrafts, trade payables and accrued expenses. It should be reviewed regularly and restructured when the need arises.

The need for financial restructuring

A company must balance debt and equity and fund any deficit. It will be forced to consider financial restructuring when:

• it needs more working capital to meet demand;
• it cannot meet its current financial commitments;
• suppliers will give it no further credit; or
• it cannot use its full production capacity for lack of working capital.

Each of these signs shows up in the numbers. Look for falling liquidity ratios, rising payables days, reliance on overdrafts and an operating cycle that has lengthened, and then say which sign the case supports before you propose any scheme.

Three types of financial restructuring

CAMA 2020, section 710, defines an arrangement as any change in the rights or liabilities of members, debenture holders or creditors of a company, or any class of them, or in the regulation of the company. Financial restructuring takes three forms:

1. capital reorganisation;
2. capital reduction; and
3. capital reconstruction.

They are ways out of financial distress and can be used alone or together. Capital reduction and capital reconstruction are often combined in one scheme. A Nigerian example is the Union Bank Plc scheme of arrangement of 2011.

Capital reorganisation

In a capital reorganisation, one or more classes of shares are cancelled or replaced by other classes. It can change the relative rights of different classes of shareholders, for example when a company takes part in a business combination.

Capital reduction

A company may want to cut its share capital to match a smaller scale of operations. More often, a capital reduction cuts the par value of shares to write off accumulated losses, so the paid-up capital falls in nominal value. Losses that have eroded the company’s value, or a large fall in the value of its assets that forces a revaluation, are the usual causes.

Conditions under CAMA 2020

A company cannot simply reduce its share capital, which for this purpose includes share premium and capital reserves. It may do so if three conditions are met:

1. its articles of association authorise a reduction;
2. members pass a special resolution at a general meeting (a resolution for reducing share capital, section 131); and
3. the court confirms the reduction on application (sections 132 and 133). Once the court order and the supporting documents are filed with the Corporate Affairs Commission, the reduction takes effect on registration (section 134).

A reduction can extinguish liability on unpaid share capital, repay capital that exceeds the company’s needs, or cancel capital that has been lost or is no longer represented by assets, with or without reducing liability. The first two reduce the net assets that creditors can look to, so creditors are allowed to object.

The court will usually confirm the scheme only if the debt of an objecting creditor is paid or secured, or the creditor consents.

When losses exceed past profits, net assets fall below permanent capital. It then makes sense to reduce capital, write off the losses and show a realistic position, so that the company can pay dividends from realised profits without first making good old losses. The simplest scheme reduces the nominal value of ordinary shares in proportion.

That does not change anyone’s real interest, because the same people still hold the same proportions of the same company.

Principles for formulating a scheme

1. Hit the ordinary shareholders hardest. They bear the main risk and enjoy the main gain when the company recovers.
2. Do not leave fixed-interest holders, such as debenture holders, worse off than they would be on liquidation.
3. Consider replacing preference shares with loan stock for a possible tax advantage, weighing the effect on gearing. Note that CAMA 2020 prohibits irredeemable preference shares.
4. Consider raising new capital through a rights issue.
5. Do the preliminary workings: total losses and the realisable value of the assets on an outright liquidation, then share that value among claimants in the order of priority, then design the scheme, summarise it and prepare the revised statement of financial position.

The usual order of priority on liquidation is: creditors with fixed charges, the costs of liquidation, preferential creditors, holders of floating charges, unsecured creditors and finally the members. Preference shareholders rank ahead of ordinary shareholders for repayment of capital where their terms say so.

Worked example

1. Reduction in net assets.
   24,000 − 18,000 = 6,000.
2. Add accumulated losses.
   6,000 + 10,000 = 16,000.
3. Less share premium.
   16,000 − 4,000 = 12,000.
   This is the capital reduction required.
4. Apply it to ordinary shares. Ordinary share capital falls from 20,000 to 8,000, that is, from 50 kobo to 20 kobo a share.
5. New statement.
   Net assets 18,000 = ordinary share capital 8,000 + preference share capital 10,000.
6. Check the interests. Preference holders keep their par value, because their dividend is based on it, and on liquidation they still receive the first 10,000. Ordinary holders take the reduction. After the scheme the company can pay dividends without first making good the old losses, so both classes gain if it recovers.

Liquidation test. If the company were wound up at the same realistic values, net assets of 18,000 would go first to the preference shareholders, who would receive 10,000, and the remaining 8,000 would go to the ordinary shareholders, which is 20 kobo for each of the 40 million shares. The scheme therefore leaves the ordinary shareholders with exactly what liquidation would give them, but keeps the company alive and able to recover.

Restructure or liquidate?

Before proposing a scheme, test whether restructuring is better than liquidation. Ask three questions. Is the underlying business viable once the structure is fixed? Would creditors receive more under the scheme than on liquidation? And would each class of investor be better off, or at least no worse off, than on liquidation? If the business is not viable, restructuring only postpones the loss.

If creditors would receive less than on liquidation, they will not agree and the court will not confirm.

A conversion of preference shares into loan stock shows the trade-offs. The holders move from owners to lenders. They gain a fixed interest claim and a higher ranking on liquidation. The company gains a possible tax deduction on interest but takes on a fixed obligation and higher gearing, so cash flow must be tested before the scheme is proposed.

Showing the effect on the statement of financial position

Present the scheme with a before and after comparison for the same company, in \u20a6 thousand.

The table shows the three effects an examiner expects you to name. The losses are gone, net assets are written down to a realistic value, and future profits can be paid out as dividends without first replacing old losses. It also shows that the preference shares are untouched, which supports the principle that ordinary shareholders bear the loss.

Common mistakes

• Forgetting that share premium counts as capital and is used first.
• Reducing the preference shares, so that the dividend base falls, when the principle is to hit the ordinary shareholders.
• Leaving out the legal steps: articles, special resolution and court confirmation.
• Ignoring creditors’ rights to object.
• Proposing a scheme without testing it against the position on liquidation.
• Treating restructuring as financial only, when the business may also need operational change.

Quick revision

• Restructuring: operational and financial. Financial types: reorganisation, reduction, reconstruction.
• Triggers: no working capital, unpaid commitments, no supplier credit, idle capacity.
• Reduction: articles authorise, special resolution, court confirms (CAMA 2020, ss. 130 to 134).
• Required reduction = fall in net assets + accumulated losses − share premium.
• Ordinary shareholders bear the loss. Lenders must not be worse off than on liquidation.

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 capital reconstruction and schemes of arrangement.

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