In the world of finance and accounting, “capital reduction” is a significant term, often abbreviated as “reduction of capital” or “capital decrease.” It refers to the process by which a company reduces its total capital for various reasons. The opposite of this concept is “capital increase” or “capital augmentation,” known as “capital injection.”

Capital reduction occurs when a corporation, such as a joint-stock company or a limited liability company, reduces its total capital. This can happen for several reasons, such as company restructuring, division, merger, or business preservation. Typically, though, capital reduction aims to correct overcapitalization or to offset deficits for a company on the brink of insolvency. In the stock market, companies facing delisting due to excessive deficit accounts in their retained earnings often resort to capital reduction to avoid delisting.

Since capital reduction deeply impacts shareholders’ interests, South Korean corporate law mandates that it must go through a special resolution at the shareholders’ meeting, and the method of capital reduction must be predetermined. Additionally, it is required to be publicly announced in daily newspapers. This is why economic newspapers like the Korea Economic Daily or Maeil Business Newspaper often feature numerous announcements related to obscure companies’ stock matters.

Types of Capital Reduction

Capital reduction can be broadly classified into two types: capital reduction with refund (paid capital reduction) and capital reduction without refund (unpaid capital reduction).

Paid Capital Reduction

Paid capital reduction, also known as “capital reduction with refund,” occurs when a company reduces its capital and compensates shareholders for the reduced portion. This typically happens during business downsizing or mergers, where shareholders receive part of the value of their stocks back. The capital is compensated to shareholders, leading to a decrease in both assets and equity on the company’s balance sheet. This is why it’s referred to as “substantial reduction.” However, paid capital reduction is rare in the stock market.

Paid capital reduction is used when a company’s capital is deemed excessively large compared to its current scale. The company buys back shares from shareholders and cancels them. While this aims to increase stock prices, it is generally considered negative news in the stock market. To facilitate smooth buybacks, companies often offer premiums, resulting in capital reduction losses. Although there might be capital reduction gains if shares are bought back below face value, losses are more common.

Unpaid Capital Reduction

Unpaid capital reduction, or “capital reduction without refund,” is when a company reduces its capital without compensating shareholders. If paid capital reduction is substantial, unpaid is more formal or nominal. It involves changes only in the equity section of the balance sheet without impacting the company’s assets.

This type of capital reduction is typically used when the company’s retained earnings fall below zero, creating significant deficits. By erasing these deficits, the company can enable future dividends and avoid capital erosion. The methods include reducing the face value of shares or consolidating and canceling a portion of the shares to reduce their number. The latter method is more commonly used, though sometimes both are combined.

If the capital reduction amount exceeds the costs for share buyback, repayment, or deficit offset, the excess is allocated to the capital reserve. Due to its significant impact on shareholders’ interests and reduction of creditor’s security, unpaid capital reduction requires a special resolution at the shareholders’ meeting and creditor protection procedures. Any leftover funds after clearing deficits are recorded as capital surplus and may later be used for capital increase or future deficit offset.

Capital Reduction Gains

Capital reduction gains occur when the amount by which the capital is reduced exceeds the costs of share buyback, repayment, or deficit offset. For instance, if a company buys back 10,000 shares with a face value of 5,000 won each for 4,000 won each, the reduced capital would be 50 million won, while the buyback cost would be 40 million won, resulting in a capital reduction gain of 10 million won.

These gains are recorded as capital surplus in the balance sheet and must be fully allocated to the capital reserve.