Difference between Internal and External Reconstruction

Nikhil Mogha

23 May, 2024

Reconstruction is the process wherein the existing company transfers its operations, assets and liabilities to a new company. In other words, it is the transfer of one or more companies into a new company. It implies that the old company shall go into liquidation, and the existing shareholders will subsequently acquire shares of equivalent value in the new company. The process of reconstruction is generally required when the company is incurring losses, and its statement of account does not show any profits. Henceforth, financially unstable companies often opt for reconstruction arrangements to move out of the financial difficulties to reconstitute their financial structure. The 2 ways through which the companies can be reconstructed are Internal and External Reconstruction. The present article will discuss in detail the meaning of internal and external reconstruction and draw a detailed differentiation between them.

Internal Reconstruction

The differentiation between internal and external reconstruction can effectively be made if the meaning and features of the internal reconstruction are adequately elaborated.

In Internal Reconstruction, the internal financial structure of the company is reorganised without dissolving the company. Under this system, the internal shape of the company is altered by the alteration or reduction of its share capital. The existing company uses this type of reconstruction to change its financial structure without dissolving its operations. Moreover, it is especially preferable for companies with a large number of accumulated losses and overvalued assets. Therefore, in general words, internal reconstruction is a type of corporate restructuring wherein the company arranges the organisation by making deliberate changes in the assets and liabilities to improve its financial position without winding up the company or transferring it to a new company.

Henceforth, it can be said that the end objective of the internal reconstruction is to provide surplus through reducing the liabilities such as alteration in the share capital, variation of the rights and settlement of creditors. This surplus received through the arrangement can then be used to write off the accumulated losses and overvalued assets. This type of reconstruction will improve the final position of the company and protects the company from going into liquidation.

Objectives of the Internal Reconstruction

1. Get rid of the fictitious assets of the company, such as discounts, preliminary expenses etc.
2. Increase the value of the assets by reducing the share capital of the company.
3. Present an accurate and fair picture of the financial position of the company.
4. Protects the company from going into liquidation.

Methods of Internal Reconstruction

1. Alteration of the share capital: The Company can alter its shares by issuing new shares, converting the fully paid-up shares with stock, cancellation of unissued capital, converting the shares into smaller units etc.
2. Variation of the rights of Shareholders: The Company may vary the shareholders’ rights when the share capital is divided into different classes.
3. Reduction of the share Capital: The company may, by special resolution, reduce the share capital of a company and extinguish or reduce the liability on its shares. It may also cancel any paid-up share capital which is not presented by available assets.
4. Surrender of Shares: Under this method, the shareholders surrender their shares to the company, which in turn is allotted to the debenture holders and creditors to reduce the company’s share capital.

External Reconstruction

From the plain reading of the internal reconstruction, it can be concluded that the internal reconstruction involves alteration or reduction of share capital; therefore, to draw the differentiation between internal and external reconstruction, it is necessary to understand the meaning and features of external reconstruction.

 In External Reconstruction, the company goes into liquidation, and its affairs are transferred to a new company. In other words, it is a process wherein the affairs of the existing company are wound up and transferred to a new company through a scheme of arrangement. The existing company having a large number of accumulated losses and is on the verge of going bankrupt adopts this type of reconstruction by transferring its assets and liabilities to a new company. It is also imperative to mention that external reconstruction is not the same as amalgamation, as, under external reconstruction, the existing company goes into liquidation, and in amalgamation, there is a combination of one or more companies into a single entity.

Under this type of reconstruction, the existing company (transferor) continues to be part of the new company (transferee) and holds a substantial interest in it, as the shareholders transferred to the new company are almost the same.

Features of External Reconstruction

1. Issuance of fresh shares of the new company through transfer.
2. Liquidation of the transferor company.
3. The transferee company undertakes to pay all the financial liabilities of the transferor company.
4. The transferee company agrees to buy the assets of the transferor company at an agreed value.

Difference between Internal and External Reconstruction

The fundamental difference between internal and external reconstruction is the formation of a company. There is no new company formation of the company under internal reconstruction as compared to external reconstruction, which requires the formation of a new company and winding up of the existing company. Further, the number of differences that can be made between internal and external reconstruction are discussed below:

Conclusion

The motive serve by internal and external reconstruction is to improve the financial position of the company by reducing the burden. It is required by the company they should undergo a financial reconstruction if they are facing financial problems. Hence, both types of reconstruction aim to protect the company from going bankrupt^[1] by rationalising the financial structure. In addition, the Companies Act 2013 governs both the internal and external reconstruction, and therefore there is a statutory obligation on the part of the company to safeguard the rights of the shareholders, creditors and debenture holders.

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