Buy back of shares must protect the investors’ interest

Harvansh P Chawla

Indian business groups, multinationals and public sector units have of late been equipped with a powerful tool to fight off corporate raiders, improve shareholder net worth or merely to restructure. The Companies (Amendment) Act, 1999 permitted companies to buy back their own shares, which has sparked off a debate.

A number of companies in the last couple of years have knocked on their shareholder doors to buy back their holdings. Though the shareholders have welcomed them their inherent discomfort with the option remains because a number of issues related to individual and small investors have been left open. There are also fears that the Securities & Exchange Board of India (SEBI) regulations are not tough enough.

Most shareholders believe that promoters will rarely buy back shares, except to protect their own interests or thwart a takeover. Besides promoters can misuse the process to prop up the market price of their shares for personal benefit.

The procedure can, however, be detrimental to the company’s health if it does not have adequate funds to buy back the shares and they are replaced with debt. The share repurchase may also send a negative signal to the stock market. Post-buyback, it can be construed in some cases, that the company has fewer growth opportunities owing to erosion of cash reserves.

The result may not be good. A quick market revival cannot be guaranteed as it is impacted by other factors. And if the performance of the company on the capital market reverses with share price drifting down post-buyback, there would be a complete erosion of the investor confidence.

Also if the buyback is simply to boost demand by reducing supply and hence push up the earning per share (EPS), this will mean allowing the remaining shareholders to gain at the cost of those opting for the buyback offer. Conversely, if the management pays too high a price for the repurchased shares, it would be to the detriment of the remaining shareholders.

However, buyback of shares have its own advantages. It can be effectively used to restructure a company’s capital. Along with the shareholders, the company can also exercise its option to return excess cash or stick to the dividend route. It can also avoid a hostile takeover by reducing the number of shares in circulation. In today’s situation, with share prices plummeting, this can be a powerful tool. It gives the PSUs an opportunity to restructure their capital and add value for the remaining shareholders besides correcting market under-valuation of their shares.

In India, however, share buyback has many stipulations. One, the ratio of debt owed by the company must not be more than twice the capital and its free reserves after a buyback is effected. Two, a company wanting to buyback its shares will not be allowed to issue fresh capital (except a bonus issue) for 12 months after the shares are bought back and extinguished. And if the shares are held as treasury stocks, the period is doubled. And prior shareholder approval for a specified buyback amount is mandatory.

The lacunae in the buyback guidelines need to be addressed like the applicability of SEBI’s takeover code. A company buying back to a certain percentage, will it necessarily have to comply with the SEBI Takeover Code regulations. For, on dilution, the proportion of shares held by the promoters would increase and set off a trigger under Regulation 10 of the SEBI Takeover Code.

Further, the takeover code gets triggered when shares beyond a specified threshold limit are acquired. This entitles the acquirer to exercise a certain percentage of voting power. In case of buybacks, there is no increased entitlement to voting rights. For, under Section 77 A (7) of the Companies Act, 1956, a company buying back its shares is not entitled to hold the same but has to statutorily cancel them. Hence, a share buyback may not entail triggering of the takeover code. Also as per the provisions of the Indian Stamp Act 1899, share transfers attract stamp duty and require the company to register the shares bought back in its name. In case of buybacks, these shares have to be statutorily extinguished. Hence, they do not get registered in the acquirer’s name. The names of the shareholders have to be struck off from the register of members too. Hence stamp duty would not become payable in a share buyback.

Further, in the case of foreign JV, where the government has permitted a fixed ratio of investment, the Indian company has to maintain the same percentage in case of a buyback. Recently, there have been reports that the government is proposing to exempt multinational joint ventures from extinguishing shares bought back, provided the foreign equity holding in the company is equal to sectoral caps post-buyback. This has not been brought into effect as yet.

(Harvansh P Chawla is a Delhi based corporate lawyer and partner in the firm K R Chawla & Co)