Capital restructuring via buy-back of shares

Sanchit Srivastava, Dr. Ram Manohar Lohiya National Law University

Editor’s note:

Companies evolve their policies continuously in order to adapt to managerial decisions, competition, politics, etc. Restructuring, therefore, becomes inevitable for operational, financial and managerial dimensions. It may be done via expansion, sell-offs, corporate control, and changes in ownership structure. One of the most important strategies in restructuring is share repurchase, or buy-back, where the company purchases its own securities from the market to either increase their or to eliminate any threats by shareholders who may be looking for a controlling stake. This also provides a one-time return of cash, and may, on the downside, send negative signals to the market regarding the company’s profit ventures, risking insolvency. Buy-back can be done via tender offer, open market purchases, and privately negotiated repurchases. These domains of company law are covered by S. 68-70 of the Companies Act 2013, which permit buy back, issue regulations, impose certain formalities, and so on. It varies vastly from the regime that had been imposed by the Companies Act, 1956. This paper also analyses the provisions in Indian law comparitively keeping the provisions of American laws in mind.

Introduction

Competitive pressures, shareholders’ demands, management decisions and regulatory and political environment, all warrant that companies keep on reinventing themselves and adapt to change. Operational, managerial and financial dimensions may therefore, often be subject to restructuring. Approaches of restructuring that a company may adopt include expansion, sell-offs, corporate control, and changes in ownership structure.

Capital restructuring is a type of business operational strategy that is employed to make changes to the capital structure of a company, usually as a way to deal with shifts in the marketplace that have impacted the financial stability of the business. Share repurchase or buy-back is one of the most important strategies that a firm uses. The procedure by which a company purchases its own securities from the market is termed as buy back of shares. The objective behind buy back may be either to increase the value of shares still available (reducing supply), or to eliminate any threats by shareholders who may be looking for a controlling stake. A company can use the share repurchase route when it has excess cash. The excess cash therefore, can be made to work on a better investment. The company can also buy back its shares from the market to thwart a hostile takeover bid.

Share repurchases or buy back may provide many benefits to companies. Share repurchases are one-time returns of cash. Rather than paying dividends companies can utilise excess cash to buy-back their shares. Apart from this, share buy-backs can be affected in a short time facilitating fast capital restructuring. However, on the flip side it is possible that repurchase of shares might send negative signals; because the market might think that the company has no profitable ventures to invest in. Since repurchases erode cash resources, the company might also lose on growth opportunities. Lastly, if the repurchase decision is mismanaged, the company could risk insolvency.

The buy-back methods include repurchase tender offer, open market purchases, and privately negotiated repurchases. The firm might issue a cash tender offer in the open market to repurchase its shares. The tender offer usually sets forth the number of shares that the company wishes to repurchase as well as the price at which it will repurchase the shares. The tender offer is also a time-bound offer and states the period for which the offer would be extended. Tender offers are mostly used for large equity repurchases.

In developed markets open market repurchases occur more often than tender offers because they are much cheaper to administer. Open market purchases can also be spread over longer time periods than tender offers. Open market purchases offers are most often used for small equity repurchases.

Negotiated purchases might be used to thwart the actions of a raiding company, which is trying to mop the shares of the target company from the market. Negotiated purchases involve a small number of investors who hold significant chunks of a firm’s shares.

Thus, the repurchase methods include:

  • capital restructuring through repurchase tender offer
  • capital restructuring through open market purchases
  • capital restructuring through privately negotiated repurchases

Besides being a strictly financial decision, share buy-back is also an information signal to the market. For example, if the firm offers to buy-back its shares at a very high premium, it might send a signal that the firm believes that its stock is undervalued. The decision to go for share buy-back or invest the spare cash in other activities is a tough one. Usually, managers and shareholders have different views on the issue. However, the management-shareholder conflict can be resolved when there are large shareholders who can monitor and discipline the management.

Ss. 77A, 77AA and 77B of the Companies Act,1956 as inserted by the Companies (Amendment) Act,1999 were the provisions regulating buy back prior to 2013. The Securities and Exchange Board of India (SEBI) framed the SEBI(Buy Back of Securities) Regulations,1999 and the Department of Company Affairs framed the Private Limited Company and Unlisted Public company (Buy Back of Securities) Rules,1999 pursuant to Section 77A(2)(f) and (g) respectively.

The Companies Act of 2013 prescribes extensive guidelines for buy back of shares within Ss. 68-70. There are a few differences between the Companies Act 1956 and the Companies Act 2013 – which shall be dealt with in detail in this project.

Buy-back of shares under Companies Act 1956

Earlier, apart from a few exceptions to Section 77, companies were not permitted to purchase their own shares. Section 77A, inserted by the Companies (Amendment) Act, 1999, has brought about a change in this fundamental concept as now a company may buy back its own shares[i].

Sub-section (1) is the indication of fund out of which the buy back is to be financed. The sources which are allowed are the company’s free reserves, securities premium account, proceeds of an earlier issue[ii]. No buy back of any kind of shares or other specified securities can be made out of the earlier proceeds of the same kind of shares or the same kind of other specified securities.

Sub-section 2 talks about the formalities. There should be a provision in the articles authorizing buy back of shares. In the exercise of that authority a special resolution at a meeting of the shareholders[iii] or a resolution of Board of Directors should be passed. In a case[iv], the Court refused to examine the propriety of every clause of the scheme or to examine the commercial wisdom of shareholders and to reject the scheme merely because a better scheme was also possible.

It was held[v] that where the resolution for purchasing the shares of the company in the market did not satisfy the statutory requirements, then that resolution was not of binding nature and was not enforceable against the company or against anyone else.

As mentioned earlier, the power may be exercised in buying back shares from the existing shareholders of the company directly or from the open market or from the employees’ sweat equity shares.

Another essential element is that a declaration of solvency has to be filed with the Registrar and SEBI[vi]. This has to be filed before the resolution for buying back is implemented. Further, where a company has resorted to the buying back of its securities, it cannot make a further issue of securities within a period of six months[vii]. It may, however, make a bonus issue and discharge its existing obligations. This restriction applies to the type of securities bought back. The company is free to issue other types of security.

Then, buy back has to be done directly and not through the medium of other companies. The section[viii] says that buy back shall not be done through any subsidiary company including the company’s own subsidiaries. It should also not be done through any investment company or a group of investment companies. A company shall not resort to buy back if it is in default in payment of deposits, redemption of debentures or preference shares or repayment of a term loan to any financial institution or a bank.

Contrast with buy back provisions of Companies Act 2013

Section 77A(4) of the Companies Act, 1956 specified that every buy back shall be completed within a period of 12 months. This led to companies dissuading from fixing an exact period for buyback, thus keeping the buyback offer open for the entire period of 12 months. However, even after keeping the buyback offer open for such a long time, there have been instances where companies did not buy a single share or failed to achieve the minimum buyback quantity. It has been observed that the companies place buy orders at their discretion instead of placing them on regular basis and that too at a price away from the market price. There were no explicit provisions in the Companies Act, 1956 or in the SEBI (Buy-back of Securities) Regulations, 1998 regarding the price or quantity for which the company shall place orders for buying back its shares or the periodicity of placement of such orders. It was also observed that buy-backs were widely employed by companies to support share price during periods of temporary weakness and to artificially increase underlying share value.

In spite of the aforementioned observations, the restriction on companies, limited by shares or guarantee and having share capital, either to purchase its own shares or to provide financial assistance for that purpose continues to be the same under the New Act. Ss. 68-70 of the Act of 2013 governs the practice of buy-back of shares. There has been a change however in relation to financial assistance to purchase shares for the benefit of employees which is allowed only if the scheme is approved by the company through a special resolution.[ix]

The following are some key changes introduced to the scheme of buy back vide the Companies Act 2013:

  1. The 2013 Act has added compliance with provisions relating to declaration of dividend as an eligibility condition for buy-back.[x]

  2. General Body approved buy-back allowed upto 25 % of total paid-up capital + free reserves. However, in case of buy-back of equity shares, the limit is replaced by 25 % of total paid-up equity capital.[xi]

Under the existing Act, buy-back of equity shares was allowed upto 25 % of total paid-up capital + free reserves subject to a second limit that buy-back of equity shares in a financial year shall not exceed 25 % of total paid-up equity capital in that financial year.

Thus, a plain reading of the provisions suggests that in case of buy-back of equity shares, entire formula, i.e. 25 % of total paid-up capital + reserves is to be replaced by 25 % of paid-up equity capital. The exclusion of free reserves would reduce the quantum of consideration substantially and make Buy-back of equity shares almost impractical in most cases. This would serve as a protection for the rights of equity shareholders of the companies.

However an alternate argument can be propounded by harmoniously construing these with provisions for Board approved buy-back which then is suggestive of the fact that the only total paid-up capital is required to be substituted by paid-up equity capital. That means in case of Buy-back of equity shares the applicable limit should be 25 % of paid-up equity capital + free reserves.

  1. The new Act prescribes a minimum gap of one year between two buy-backs. Under the 1956 Act, this provision was applicable only in relation to Board approved buyback. Under the new Act it is applicable even to a General Body approved buy-back. Therefore, multiple Buyback in a year should not be possible under the New Act.[xii]

  2. The existing Act provided for transfer to the extent of nominal value shares to the Capital Redemption Reserve (CRR) referred to in relation to redemption of preference share. Both the Acts provide that provision relating to reduction of capital apply to such CRR. However, the New Act provides for creation of CRR without reference to CRR in relation to redemption of preference shares[xiii] and therefore prima facie it seems, though may be unintended, the provisions relating to reduction of capital may not be applicable to CRR in relation to Buy-back. The New Act also specifies utilization of capital redemption reserve created in relation to Buy-back for issuing bonus shares.[xiv]

  3. The mode of buy-back of odd lots which was provided under the 1956 Act has been removed from the scheme vides the 2013 Act.

  4. The 1956 Act did not allow a company to buy-back, if the company had defaulted in repayment of deposits, redemption of debentures etc. till the time default persisted. Under the new Act a company which has defaulted as above is not allowed to buy-back for a further period of three years even after the default is remedied.[xv] This allows the shareholders to save themselves from an error in accounting committed by the company, which could cost them dearly in terms of their rights therein in case of a buy-back.

  5. No compromise or arrangement shall include buy-back of securities unless it is in accordance for buy-back provisions.

Share repurchase provisions in US law: A brief overview

Since American corporations generally have broad powers to deal in their own shares, it follows that they may acquire their own shares from their shareholders.[xvi] Although there was some doubt in earlier cases as to the powers of a corporation to acquire its own shares, these powers are now commonly authorized expressly by the governing corporate statutes.[xvii]

The basic aim of the statutory provisions regulating share repurchases is to provide a minimal level of protection against depletion of corporate assets available for creditors.[xviii] Like cash dividends, share repurchases represent a transfer of wealth from the corporation to its shareholders without a change in the ownership structure of the firm.[xix] The law is concerned with excessive share repurchases that might deplete the corporation’s funds. As with dividends statutes, states regulate share repurchases under either a legal capital or insolvency regime, so financial restrictions on share repurchases can be divided into two types.

Via the limitation by surplus concept, many state corporation statutes prohibit a corporation from repurchasing its shares when it has no surplus or when it would be rendered insolvent by the transaction.[xx] This fundamental prohibition is designed to protect corporate creditors by insuring that a corporation will have sufficient assets left, after a distribution to its shareholders, to pay its existing debts.[xxi]

The Model Business Corporation Act 1971 (“MBCA”) provides that a corporation shall have the right to purchase its own shares to the extent of “unreserved and unrestricted earned surplus”[xxii] available therefor.[xxiii] It also provides that, if the articles of incorporation so permit or with the affirmative vote of the holders of a majority of all shares entitled to vote thereon, a corporation may purchase its own share to the extent of unreserved and unrestricted “capital surplus”[xxiv] available therefor.[xxv] S. 6 of the Act prescribes the situations in which a corporation can purchase its own shares – (i) eliminating fractional shares, (ii) collecting or compromising indebtedness to the corporation, (iii) paying dissenting shareholders entitled to payment for their shares, (iv) effecting the retirement of its redeemable shares by redemption or by purchase.[xxvi] The New York Business Corporation Law (“N.Y. Bus. Corp. Law”) generally permits repurchases only out of surplus.[xxvii] When shares are repurchased out of stated capital, they shall be cancelled.[xxviii] However, the Delaware General Corporation Law (“Del. Gen. Corp. Law”) prohibits the repurchase of common share if the repurchase would impair the capital of the corporation.[xxix]

It would be interesting to note at this juncture that a share repurchase may be legal and yet may be voidable in equity on the ground that it was not made in good faith and for a proper motive.[xxx] There is nothing inherently wrong with a board’s trying to keep itself in control of a corporation. Therefore, if the directors determine in good faith that repurchase of shares will benefit the corporation, the repurchase will not be invalidated by a court of equity.[xxxi] However, if there was a conflict of interest on the part of some or all of the directors, different standards apply to those directors charged with self-dealing.

Conclusion

The purpose of buy-back is primarily to protect the interests of the shareholders and the creditors of the company and also to prevent the management thereof from unjustly enriching themselves by trafficking in the company’s own shares. The question while examining the provisions at hand is whether this purpose has lost significance owing to the legal setup.

In India, the current law on share repurchase should be moulded and amended in accordance with the current environment of the country. In India at present even though there are regulatory bodies such as SEBI and other mechanisms in place, these mechanisms have been proved inadequate and faulty by the rampant corporate scams. In such a situation allowing an unrestricted, free provision for buy back of shares can result in share price manipulation and concentration of power in hands of the management at the cost of small shareholders.

Further, the proposition of a liberal regime of share repurchase looks increasingly unattractive in the light of other provisions in the Companies Act which regulate and prevent hostile takeovers.

The above mentioned being said, with the proposed introduction by the Finance Bill 2013 of a tax on buy-back and the increased restrictions introduced by the Companies Act 2013, companies may be discouraged from buying back shares as a method by which to disburse excess cash or increase the value of shares. Through these changes, the Companies Act will no longer be a route to avoid tax and reduce share capital while avoiding the need for a protracted court process.

Edited by Neerja Gurnani

[i] Avtar Singh, Company Law (15th edn Eastern Book Company, 2009) 260-61.

[ii] The Companies Act 1956, s 77A (1).

[iii] Gujarat Amiya Exports Ltd, Re (2004) Comp Cas 265 Guj.

[iv] Id.

[v] Vision Express (UK) Ltd v Wilson (No 2) (1998) BCC 173.

[vi] Supra. note 2, s 77A (6).

[vii] Supra. note 2, s 77A (8).

[viii] Supra. note 2, s 77B.

[ix]The Companies Act 2013, s 68 (5).

[x] Supra, s 68 (1).

[xi] Supra., s 68 (2) proviso.

[xii] Supra. note 2.

[xiii] Supra., s 69 (1).

[xiv] Supra., s 69 (2).

[xv] Supra. note 1, s 70 (1) (c).

[xvi] 11 Zolman Cavitch, ‘Business Organizations with Tax Planning’ 147-11 (1997).

[xvii] Harry G. Henn, Law of Corporations (West House 1983) 349.

[xviii] Robert C. Clark, Corporate Law (Little, Brown and Co. 1986) 636.

[xix] Robert M. Lawless et al., ‘The Influence of Legal Liability on Corporate Financial Signaling’ 23 J. Corp. L. 209, 230 (1998).

[xx] See, e.g., Illinois (Ill Rev Stat ch 32, § 9.10); Maryland (Md Corp & Ass’ns Code Ann § 2-311); Indiana (Ind Code § 23-1-28-1 et seq.); Massachusetts (Mass Gen Laws Ann ch 156B, §§ 45, 61); Michigan (Mich Comp Laws § 450.1365); Virginia (Va Code § 13.1-653).

[xxi] Supra. note 17 at 147-19.

[xxii] MBCA, § 2(l).

[xxiii] MBCA, § 6.

[xxiv] Supra. note 23.

[xxv] Supra. note 24.

[xxvi] Supra.

[xxvii] NY Bus Corp Law, § 513.

[xxviii] NY Bus Corp Law § 515(a).

[xxix] Del Gen Corp Law § 160(a).

[xxx] Zahn v Transamerica Corp, 162 F.2d 36 (3d Cir. 1947).

[xxxi] Supra. note 17 at 147-33.

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