Restrictions on Company Purchasing Own Shares

“There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated.” [1]

– Warren Buffet,

American Investor, Industrialist, Philanthropist

Section 77 of the Companies Act, 1956 (hereinafter called the Act) restricts the buyback of shares by a company. To quote “No company limited by shares, and no company limited by guarantee and having a share capital, shall have power to buy its own shares.” [2] Every rule has its exceptions, so Section 77(1) allows a company to buy back its own shares if a “consequent reduction of capital is effected and sanctioned” in accordance with the procedure laid down by sections 100 to 104 or of section 402. But before we deal with the procedural aspect of buying back shares, it is important to understand the rationale behind this provision of the Act.

Recently the Companies Bill 2009 which is still pending discussion in the Parliament has a provision on the restriction of purchase of shares by the company itself. [3] The Amendment says

Clause 60. — This clause corresponds to section 77 of the Companies Act, 1956 and seeks to provide the restrictions on purchase by companies or giving loans to others for purchase of its own shares. This clause further provides that the company’s right to redeem any preference shares issued by it is not affected by such restriction.

Clause 61. — This clause corresponds to section 77A of the Companies Act, 1956 and seeks to provide that a company may purchase its own shares out of its free reserves, the securities premium account or from the proceeds of the issue of any shares or other specified securities. The clause provides for the conditions to be fulfilled for buy-back of securities.

Every buy-back should be completed within one year from the date of passing of the special resolution. A declaration of solvency has to be filed by the company to the Registrar and SEBI before the buy-back is proposed. After completion of buy-back a return has to be filed with Registrar and Securities and Exchange Board of India. After buying back, the company shall physically destroy all the shares.

Clause 62. — This clause corresponds to section 77AA of the Companies Act, 1956 and seeks to provide that in case of buy-back of shares out of free reserves, a sum equal to the nominal value of the shares so purchased shall be transferred to capital redemption reserve account.

Clause 63. — This clause corresponds to section 77B of the Companies Act, 1956 and seeks to prohibit buy-back through any subsidiary company, through any investment company or through such company which has defaulted in making repayment of deposits, interest thereon, redemption of debentures, payment of dividend, etc.

At the time of drafting the legislation, there was a feeling that if companies were allowed to buy-back their shares, it would generate incentive for companies to traffic in their own shares. [4] This would, it was felt, lead to unhealthy stock market practices such as insider trading or other similar attempts by a company to influence the value of its shares. [5] The debate on whether the buyback of shares by a company should be permitted has been an ongoing one for several decades. The strongest argument for permitting buyback is that the restrictions on the purchase by a company of its own shares were motivated by the Doctrine of Maintenance of Capital. This doctrine was a result of the concern for creditors when the concept of limited liability was created and creditors’ could not approach individual directors of the company for repayment of their debts. The concern was that the company’s capital should not be diluted by decrease in its convertible assets. If the company maintains a required amount of assets, the chances of the creditors’ debts being met would be greater. In Trevor v. Whitworth [6] , the House of Lords very succinctly said that

“paid-up capital may be diminished or lost in the course of the company’s trading: that is a fact which no legislation can prevent; but persons who deal with, and give credit to, a limited company, naturally rely upon the fact that the company is trading with a certain amount of capital already paid, as well as upon the responsibility of its members for the capital remaining at call; and they are entitled to assume that no part of the capital which has been paid into the coffers of the company has subsequently been paid out, except in the legitimate course of its business.”­ [7]

Thus, we come to Section 77 of the Companies Act, 1956 which reflects this same concern for creditors. Later, the recommendations of a Working Group on Companies Act, 1956 constituted by the Central Government, led to insertion of section 77A and 77B. This Amendment was suggested to bring Indian law in parity with its British counterpart. Thereafter, the concept of Buy-back of securities which was proposed in the Companies Bill, 1997 was incorporated in the Companies Act by the Companies (Amendment) Ordinance 1998.

Section 77A of the Act refers to the power of a company to purchase its own Securities subject to the provisions of Section 77A(2) and section 77B of the Act. The Securities and Exchange Board of India (SEBI) has issued the SEBI (Buy-back of Securities) Regulation 1998, which are applicable to listed company on a stock exchange. The other companies are regulated by Private Limited Company and Unlisted Public Limited Company (Buy-back of Securities) Rules, 1999.

Why do companies Buyback Shares? [8]

The repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies will buy back shares 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. [9]

The main reason companies buy back their own shares is to switch cash from mature sectors and investments to new sectors or expanding companies. Share buybacks are an increasingly frequent and healthy phenomenon. When there are no investment opportunities offering a return commensurate with the required rate of return, management returns cash to shareholders, who, presumably, can find investments that meet their requirements. Here we are reminded of M. Jensen’s theory of free cash flow: when a company buys back its own shares, at least it is not undertaking a risky diversification or massively over-investing!

Shareholders and management can have other reasons for wanting to buy back shares:

A change in the relative weighting of shareholders between those who refuse to sell their shares to the company for reasons of control (i.e. in order to increase their percentage of ownership) and those who agree to sell some of their shares, hopefully at above their market value. This happened recently with Peugeot.

Tax reasons, as it is often less costly for shareholders to get cash in the form of a share buyback than in the form of dividends;

To send out a positive signal, i.e. that management considers the company to be undervalued. Buying back shares and cancelling them increases the value of the remaining shares. Given the recent movements in some stocks, this can be a very strong incentive.

Leverage from debt, for the related tax benefits. This is not a very compelling motivation, as it overlooks the fact that debt and equity become riskier after a share buyback and thus more costly. The tax benefit is often illusory, especially as the company loses some financial flexibility. If share buybacks reduced WACC, companies would always be massively buying back their shares!

Building up a reserve of shares to be used later for stock option awards or as a currency for an acquisition.

Smoothing out share price fluctuations in the case of listed companies. But whatever is bought can be resold, and such buybacks, which are often in tiny doses, are tightly regulated by market authorities;

Creditor considerations: share buybacks reduce a company’s solvency and thus increases its risk and diminishes the value of its debt. But as creditors can oppose a capital reduction, this reason is quite academic.

Method of Buying Back Shares

Buy-Back of shares is nothing but reverse of issue of shares by a company. It means the purchase of its own shares or other specified securities by a company. In case of buy-back, a company offers to take back its shares owned by the investors at a specified price generally determined or arrived at on the basis of the average price of the shares in the past few months. This calculation is usually done at a premium on the market price so as to attract more number of investors, which may vary as per the financial prudence of the company. Thus, buy-back is one of the prominent modes of capital restructuring.

The decision to buy-back is influenced by various factors relating to the company, such as growth opportunities, capital structure, sourcing of funds, cost of capital and optimum allocation of funds generated.

Sec77    –     Restrictions on purchase by company, or loans by company for purchase, of its own or its holding company’s shares

(1) No company limited by shares, and no company limited by guarantee and having a share capital, shall have power to buy its own shares, unless the consequent reduction of capital is effected and sanctioned in pursuance of sections 100 to 104 or of section 402.

(2) No public company, and no private company which is a subsidiary of a public company, shall give, whether directly or indirectly, and whether by means of a loan, guarantee, the provision of security or otherwise, any financial assistance for the purpose of or in connection with a purchase or subscription made or to be made by any person of or for any shares in the company or in its holding company :

Provided that nothing in this sub-section shall be taken to prohibit :

(a) the lending of money by a banking company in the ordinary course of its business ; or

(b) the provision by a company, in accordance with any scheme for the time being in force, of money for the purchase of, or subscription for, fully paid shares in the company or its holding company, being a purchase or subscription by trustees of or for shares to be held by or for the benefit of employees of the company, including any director holding a salaried office or employment in the company ; or

(c) the making by a company of loans, within the limit laid down in sub-section (3), to persons (other than directors or managers) bonafide in the employment of the company with a view to enabling those persons to purchase or subscribe for fully paid shares in the company or its holding company to be held by themselves by way of beneficial ownership.

(3) No loan made to any person in pursuance of clause (c) of the foregoing proviso shall exceed in amount his salary or wages at that time for a period of six months.

(4) If a company acts in contravention of sub-sections (1) to (3), the company, and every officer of the company who is in default, shall be punishable with fine which may extend to ten thousand rupees.

(5) Nothing in this section shall affect the right of a company to redeem any shares issued under section 80 or under any corresponding provision in any previous companies law.

Transfer of certain sums to capital redemption reserve account

Where a Company purchases its own shares out of free reserves then a sum equal to nominal value of the shares purchased has to be transferred to the capital Redemption Reserve Account referred to in clause (d) of the proviso to sub section (1) of section 80 and its details are required to be disclosed in the balance sheet. Such a transfer of capital redemption reserve account will not be required when buy-back of securities is other than sharers. Further, the Central Government may, from time to time notify other securities as specified securities and such notified securities may not be shares.

CRITICAL ANALYSIS

Appreciation

This scheme is advantageous to the Companies as:

1. Companies may buy-back its shares to take advantage of low share prices and hope that their value will rise quickly.

2. A company considering that its share price has been unfairly lowered buy-back them to give the price a boost.

3. A company with excess cash may choose to buy its own shares rather than give out dividends. Once a company gives out dividends, investors expect them to be passed out regularly. But if the company’s cash dwindled in future years, it might have to cut the dividend and anger shareholders.

4. A company could be taking advantage of the lower price to infuse its employee stock option program.

5. A company may buy-back it shares to safeguard itself from hostile takeover bids.

Criticism

However, there are certain drawbacks and areas of concern in the legislation:

1. One of the conditions for the purchase of its own shares mentioned in sub-section 2 of 77A of the Companies Act for a company whose shares are listed on a recognized stock exchange is that such a buy-back should be in accordance with the regulations made by SEBI in this behalf. [10] It is thus very crucial to look at the definition of the term ‘recognized stock exchange’ under the Act. As per section 2(39) of the Act ‘Recognized stock exchange’ means, in relation to any other provision of this Act, in which it occurs, a stock exchange which is notified by the Central Government in the Official Gazette as a recognized stock exchange for the purpose of that provision. Till date the Central Government has not recognized a stock exchange for the purpose of section 77 A. The absence of such a notification is a fatal omission as in the purchase of its own securities made by a listed company under this act is technically invalid and cannot be acted upon.

2. Under section 115-o of the Income Tax Act, 1961, dividend tax at the rate of 10 % has to be paid on any amount declared, distributed or paid by way of dividend by any domestic company. However, buy-back of shares made under section 77A of the Act is not treated as dividend by virtue of sub clause (iv) of clause (22) of section 2 of the Income tax Act. It is not mandatory for a company to declare dividend under the Act. Taking advantage of this legal provision, a subsidiary may refrain from declaring dividend and transfer the entire or substantial profits to reserve. Then it can buy-back 25% of the shares at book value, which in any case will be more than the face value. These companies can wait for 6 months and issue further shares to the extent brought back. This process can be repeated any number of times. Thus, buy-back can be used to repatriate profits without paying dividend taxes by subsidiaries of foreign companies. Similarly, subsidiaries of Indian companies can also distribute profits without paying any dividend tax.

3. Most of the buy-back taken place to enhance promoter’s holdings in the company rather than with a view to enhance shareholder’s wealth.

4. In case of the multi-national companies, buy-back has been motivated by a desire to get the company de-listed from the Indian bourses. Under the present guidelines, if the promoters are able to get more than 90% shares, law permits the delisting.

5. There is no restriction on repeated buy-backs year after year, which has resulted in increasing promoters equity stake ultimately.

6. There is reduced cooling off period of 6 months between a buy-back and re-issue of same kind of shares within a specified period.

7. There are reports of insider trading in some of the cases before the buy-backs are announced.

International Scenario

While talking about interna­tional scenario, the environment prevailing in the U.S. and U.K., Canada, Australia and New Zealand shall be referred to. [11] Indian laws are very similar to the laws prevalent in the U.K. so the U.K. scenario is comparable to the position in Indian. [12]

US

A company in the U.S. may purchase its shares in any one of the follow­ing ways – (i) fixed price tender offer (ii) Dutch auction repurchase (iii) open market repurchase and (iv) private negotiation and may finance the offer either by cash or by debt. [13] The company’s Articles of Association must allow it to do so and a Board Resolution must be passed at the directors’ meeting. [14] There is however no statutory limit on the buyback program size or duration in the U.S. No matter by whichever method a company buys back its own shares in the U.S., it must not violate the anti-manipulative and anti-fraud provisions of Rule 10b­18 of the Securities and Exchange Act, 1934. [15] Shares bought back by the U.S. companies must be held in ‘treasury’ for the purpose of reissu­ing them in future. [16] Surprisingly, there is a lack of statute in the U.S. imposing penalty on the companies for failing to implement a buyback program or for non-compliance with buyback provisions. [17]

UK:

Section 162 of the U.K. Companies Act, 1985 allows a limited company to purchase its own shares subject to an authority in its articles. In the U.K., a company can purchase its own shares either through off-market or on-market or through contingent purchase contracts. [18] An ordinary resolution is required for on-market purchases whereas off-market purchases must be authorised by a special resolution. [19] In either case, the said resolution must specify the limits as to the maximum number of shares proposed to be bought back, maximum and minimum buyback prices etc. [20]

A buyback transaction in the U.K. may be financed either out of distributable profits or out of proceeds of a fresh issue made specifically for buyback purposes or out of capital in case of private companies only provided that the profits together with the proceeds of fresh issue fall short of the amount required for buyback. [21] Unlike U.S.A., treasury opera­tions are not allowed in U.K. Under Section 178 of the U.K. Companies Act, shareholders have the right to seek specific performance of the contract to repurchase shares if the com­pany fails to implement the buyback program. [22] Moreover, company’s directors may be personally liable and may commit offence in the event of noncompliance with buyback provisions. [23]

CONCLUSION

With the present competitive environment in India arising due to globalization and multi-nationals entering into the Indian market; it was felt that Indian companies need flexibility. Though the response to buy-back option was lukewarm in the beginning, the situation is changing and the provisions have received laudable response from the corporate world. Since the approval of buy-back of shares by companies, there has been commendable shoot up in the instances of buy-back. There are undoubtedly certain drawbacks in the Buy-back of securities in India but the benefits far outweigh the criticism. Thus, enabling Indian companies to buy-back its own shares is clearly a step towards fulfilment of long-standing demand towards liberalization of company law.