Penny wise, pound foolish

Proposed changes in buyback provisions will encourage insider trading

Kumkum Sen

Under the provisions of Section 77 of the Companies Act, 1956, a company was prohibited from purchasing its own shares. It was thought that such unhealthy trafficking in its own shares by a company was detrimental to its creditors, who lent on the assumption of a company having a certain amount of paid up capital, for which the shareholders were responsible.

However, this concept came up for reconsideration in the light of corporate sector growth and shareholder values. Accordingly, the Working Group constituted by the central government recommended share buyback, subject to certain checks and balances, with the purpose of enhancing shareholder value, improving capitalisation rates, preventing hostile takeovers, and providing a cash-beneficial exit route to minority investors.

Accordingly, Sections 77A and 77B permitted a company to buy back its shares from specified funds, subject to authorisation by its Articles of Association and passing of a special resolution. Shares could be bought back up to an amount of 25 per cent of its total paid up equity capital or 25 per cent of the total paid up capital plus free reserves in a year. Buyback could not be made from the proceeds of an earlier specified issue — though how early in time such an issue had to be was not clear. Nor was it clear whether such an issue was only of shares or included other securities. The buyback could be made only of fully paid up equity shares. The company was required to maintain a particular debt-equity ratio and restrained from making an issue of the same kind of shares as those sought to be bought back for the next two years. In addition, stringent regulatory norms were laid down to safeguard investor and creditor interest.

But the buyback provisions failed to fulfill the expectations generated. Very few actual buybacks took place, and those companies which did carry out the exercise failed to sustain the increase of the share price in the market. The result was that the companies lost out and the shareholders — whose shares were bought back — gained. There was no perceptible increase in the earning to existing shares nor a better capitalisation rate.

With the corporate sector passing through an unprecedented low ebb and the winter session of Parliament two months away, the Companies Amendment Ordinance for Amendment of Buybacks Provisions was promulgated. The main provision was that in case less than ten per cent of the total paid-up equity capital and free reserves of a company (a new combination) was being bought back, a board resolution would suffice, instead of the originally mandated special shareholder resolution. Further, the limit of 24 months for a further issue of the same kind of share after completion of one round of buyback was reduced to six months.

The ordinance, with the follow-up Companies (third) Amendment Bill, 2001, has generated controversy in corporate and investor circles, and for good reason. First, there is a presumption that the lack of activity on the buyback front is due to small shareholder intransigence and/or the procedural rigidities involved. The transfer of buyback powers to the board up to ten per cent of the paid up equity and free reserves combination is thus intended to facilitate transactions of a smaller magnitude.

Further, the reduction of the time period has permitted company managements not only more repeats of the buyback exercise, but also re-engineering of the shareholding pattern. In this connection, it is significant that the mandatory disclosure in the notice of the general body meeting envisaged in the existing Section 77A(3) is not applicable, in case the buyback is within the ten per cent norm by the board resolution route. The simple reason is that such a detailed justification is not required for a board decision. But this is precisely where transparency gets clouded. The information for buyback up to ten per cent need not reach the shareholders at all. Effectively, the board can manoeuvre buyback up to the twenty five per cent limit every year, bypassing all other stakeholders.

The absence of such a crucial safeguard has alarmed investors. Only time and actual results will indicate how far the amendments envisaged will facilitate buyback and enhance shareholder value etc. Otherwise, the amendment is inimical to the protection of the minority shareholders and creditors by allowing the large shareholder, ie the promoters and institutions, access to market-sensitive information, thereby opening the door for insider trading and other manipulations.

The hastiness in introducing these changes indicates the insecurity in the minds of the lawmakers. Not all financial and commercial problems can be resolved through legislative changes, when existing laws prove ineffective for reasons outside the pale of law. How will it help the cause of Corporate India if greater control is achieved at the cost of driving out investors from the market?

Kumkum Sen is a corporate lawyer and partner in Khaitan & Khaitan, a Delhi law firm