“Every time a listed company announces a reduction of its capital, investors divide between those who see it as the beginning of recovery and those who regard it as a belated admission of the crisis.”
In recent years Boursa Kuwait has seen a growing number of capital reductions, amid the restructuring pressures facing some listed and unlisted companies, whether because of accumulated losses or in order to reorganise their financial structure. As these transactions have recurred, capital reduction has turned from a marginal accounting procedure into a strategic decision that investors watch for with every disclosure season.
The process has come under close scrutiny by the Capital Markets Authority, which insists on protecting the rights of shareholders and creditors alike. The question is no longer why the company is reducing its capital, but how, and from which line item in the balance sheet, that will be done.
At a time when a number of companies are resorting to reducing their capital, investors ask: when is the reduction a financial remedy that restores balance to the balance sheet, and when does it turn into a warning sign? The answer lies in the details of shareholders’ equity, and in the order imposed by Companies Law No. 1 of 2016.
A capital reduction is not a free decision in the hands of the board of directors; it is a legal and regulatory process that starts at the Ministry of Commerce and Industry, passes through the regulatory authorities, and is also subject to the rights of creditors and their objections, given that capital represents one of their most important legal safeguards.
Five situations that drive Kuwaiti companies to reduce capital
1 – Extinguishing accumulated losses
When losses exceed 50% of capital, the law prohibits the company from distributing profits. Here companies resort to writing off part of the capital against the extinguishment of the accumulated losses, with the aim of cleaning up the balance sheet and regaining the ability to distribute. Among the most prominent examples is Al Mazaya Holding Company, which in 2020 reduced its capital from KD 63 million to KD 48 million to extinguish accumulated losses amounting to KD 15 million.
Markets often react cautiously to this type of reduction, because the investor looks not only at the accounting treatment but at management’s ability to prevent the losses from recurring in future.
2 – Capital in excess of operating needs
Some companies, particularly banks and industrial companies, hold liquidity in excess of their expansion needs. In this case the surplus is returned to shareholders through a capital reduction and the distribution of cash amounts. Examples include Kuwait Cement Company, which returned part of its liquidity to shareholders through capital reductions on more than one occasion.
3 – Cancellation of treasury shares
When a company buys its own shares from the market and then cancels them, issued capital decreases automatically. Kuwait Finance House and Boubyan Bank are among the most prominent entities to have used this method, which the regulatory authorities regard as a “clean” reduction because it raises the return per share without touching the losses.
4 – Restructuring after a merger
After some mergers, an inflation of capital may appear that is not matched by real growth in productive assets, which prompts companies to reset the capital structure.
5 – Sale of a material asset or liquidation of an activity
Where a factory or an entire operating segment is sold, the company may move to reduce capital by the value of the asset sold and return part of the proceeds to shareholders.
The mandatory order for absorbing losses
If the aim of the reduction is to extinguish losses, Kuwaiti law and international accounting standards impose a strict sequence that may not be bypassed.
Stage one: exhausting distributable profits and reserves
- Retained earnings come first.
- The voluntary reserve.
- The statutory reserve.
- Share premium.
Stage two: touching capital
Capital may not be reduced until all the preceding items have been exhausted, so that the reduction becomes, as it were, “the remedy of last resort”.
Three items that are off limits
According to one of the press articles issued by Al-Waha Auditing Office, “attempts to use the revaluation reserve to extinguish losses are among the points that most often meet regulatory objection, as it does not represent realised profits available for distribution or absorption”.
- Revaluation reserve: it represents unrealised gains arising from the increase in the value of assets, and may not be used to extinguish losses.
- Foreign currency translation reserve: it arises from exchange rate differences and is realised in fact only on exit or liquidation.
- Treasury shares: cancelling them leads to a reduction of capital but does not address the accumulated losses.
Indicators the shareholder should watch for
| If the disclosure states | What does it mean? |
|---|---|
| Reduction to extinguish losses | The company’s results over recent years should be reviewed to find out whether the losses are recurring |
| Reduction with a cash return to shareholders | Usually a positive signal reflecting surplus liquidity at the company |
| Reduction before a capital increase | May be an indicator of the company’s recurring need for liquidity at shareholders’ expense |
| Mention of the revaluation reserve | A signal that calls for caution, because the regulatory authorities usually do not approve its use |
The procedural steps required in Kuwait
- Preparation of a report by the auditor setting out the size of the losses and the mechanism for covering them in accordance with the legal order.
- Approval of the extraordinary general assembly by not less than 75%.
- Granting creditors an objection period of 30 days through official publication.
- Obtaining the approvals of the regulatory authorities, foremost among them the Kuwaiti Ministry of Commerce and Industry, and the Capital Markets Authority in the case of listed companies.
How do capital reduction procedures differ across the Gulf?
Although the general rules are similar across the Gulf Cooperation Council states, the mechanisms for reducing capital differ from one market to another according to the degree of regulatory stringency and the nature of the legal systems.
In the Kingdom of Saudi Arabia, listed companies are subject to strict oversight by the Capital Market Authority, and a detailed report by the external auditor is usually required, setting out the effect of the reduction on the company’s solvency and its continuity as a going concern, in addition to the approval of the extraordinary general assembly. In the United Arab Emirates, the procedures are marked by relatively greater flexibility, particularly in the financial free zones; listed companies nevertheless remain subject to the approvals of the regulatory bodies and the financial markets, with a focus on protecting creditors’ rights and advance disclosure to investors.
In Qatar and Bahrain, the regulatory authorities follow an approach similar to Kuwait’s in requiring the approval of general assemblies and allowing an objection period for creditors before the reduction is completed. Specialists believe that the regulatory tightening in the Gulf states in recent years reflects a broader drive to strengthen governance and to prevent capital reduction being used as a means of cosmetic accounting treatments that do not reflect the true financial reality of companies.
When is a reduction healthy?
A capital reduction is a positive indicator when it is accompanied by:
- A clear operational improvement.
- Stable cash flows.
- An announced plan for restructuring and improving profitability.
By contrast, the reduction turns into a danger signal when:
- It is repeated within short periods of time.
- It immediately precedes a capital increase.
- Or it takes place without any real change in management or operating activity.
Conclusion
With the Capital Markets Authority tightening its review of capital reduction applications, the investor now faces a clearer equation. The Authority is no longer content with formal approval; it scrutinises the sources of cover and rejects any attempt to circumvent the legal order of absorption.
An investment manager at one of the Kuwaiti brokerage firms says: “A capital reduction is like the surgeon’s scalpel: it may save the company and return it to recovery, and it may sometimes turn into an attempt to prettify a balance sheet that still suffers from the very same imbalances.”
And in a market where the regulatory authorities no longer tolerate cosmetic treatments, capital reduction has become a real test of management’s transparency before it is a mere accounting procedure.