A capital redemption reserve fund exists on a company’s financial statements and as part of the company’s internal accounts. U.S. Security and Exchange Commission regulations require a capital redemption for certain transactions as a hedge against incurred capital reduction. Until a company liquidates, it can neither distribute funds from the capital redemption reserve to shareholders nor use the proceeds from the fund for any purpose.
A capital redemption reserve is an established fund that holds money to protect a company from the loss of capital. A company protects itself from such a loss by essentially setting aside the amount of capital required for the specific transaction. By maintaining the capital redemption reserve, the company can set aside adequate funding to pay creditors in the event that it runs into financial problems. It can use the capital redemption reserve for specific purposes with court approval.
When the Reserve Is Utilized
According to “Principles of Finance,” by Scott Besley and Eugene Brigham, the most common situation that requires a company to create a capital redemption reserve is a redemption of shares. Per SEC regulations, any time a company buys back its own shares with capital or with new shares, it must put the same amount of money into a capital redemption reserve. The fund, therefore, offsets the reduction of the company’s equity as a result of the share buyback. The company must set aside the same amount of capital in a capital redemption reserve fund when it purchases the shares with company profits.
Purpose of a Capital Redemption Reserve
The capital redemption reserve holds funds that a company may use to meet its continuing obligation to creditors. The reserve functions as a protector of the company’s equity. The fund itself is not distributable. This means the company can use the funds for no purpose beyond that of maintaining company equity or issuing bonus shares. Ultimately, the capital redemption reserve protects a company’s creditors.
When the Reserve Does Not Apply
The legal requirement to establish a capital redemption reserve when a company buys back its own shares does not apply in all cases. When private companies whose shares are not bought and sold by the general public, repurchase shares, they do not have to establish such a reserve. A public company can sometimes obtain a court order allowing it to buy back shares without establishing a capital redemption reserve.