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COMPANY LAW

PROJECT REPORT ON

“BUY BACK OF SHARES”

SHIVA PATEL

3^rd year, NATIONAL LAW INSTITUTE UNIVERSITY

BHOPAL

INTRODUCTION

Be it a listed or unlisted company, share capital will bear an integral part in company setup . Share capital can be of two types i.e. equity share capital or preferential share capital. The share capital of a company has to be subscribed by one or more persons. After the share of a company has been allotted to the subscribing members, the subscribers have no right over the money gone as proceeds of the shares subscribed. All that the shareholder has is the right to vote at the general meetings of the company or the right to receive dividends or right to such other benefits which may have been prescribed. The only option left with the shareholder in order to realize the price of the share is to transfer the share to some other person.

But there are certain provisions in the companies act which allow the shareholders to sell their shares directly to the company and such provisions are termed as buy back of shares. Buy back of shares can be understood as the process by which a company buys its share back from its shareholder or a resort a shareholder can take in order to sell the share back to the company.

The provisions regulating buy back of shares are contained in Section 77A, 77AA and 77B of the Companies Act, 1956. These were inserted by the Companies (Amendment) Act, 1999. 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.

HISTORY

Prior to the amendment of the 1999 of the companies act there was no way a company could buy its shares back from the shareholders without a prior sanction of the court (except for the preferential shares). The laws as to the buying of its share by the companies were very stringent. Some of the ways by which a company could buy its shares back were as follows:-

(i)   Reduction of share capital as given in sections 100 to 104.

(ii)   Redemption of redeemable preferential shares under section 80.

(iii)  Purchase of shares under an order of the court for scheme of arrangement under section 391 in                          compliance with the provisions of sections 100 to 104.

(iv)  Purchase of shares of minority shareholders under the order of the company law board under section 402(b).

Though there were ways by which a company could buy its shares back from the shareholders but it could not be done without the sanction of the court. This was done to protect the rights of the creditors as well as the shareholders. But the need of less complex ways of buying its shares back by the company was always felt. The much needed change in the companies act was brought about by the companies amendment act 1999.Sections 77A, 77AA and 77B were inserted in the companies act by this amendment.

The provisions regulating buy back of shares are contained in Section 77A, 77AA and 77B of the Companies Act, 1956. These were inserted by the Companies (Amendment) Act, 1999. 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.

Why  do companies buyback? 

* Unused Cash-If they have huge cash reserves with not many new profitable projects to invest in and if the company thinks the market price of its share is undervalued. Eg. Bajaj Auto went on a massive buy back in 2000 and Reliance's recent buyback. However, companies in emerging markets like India have growth opportunities. Therefore applying this argument to these companies is not logical. This argument is valid for MNCs, which already have adequate R&D budget and presence across markets. Since their incremental growth potential limited, they can buy back shares as a reward for their shareholders. 

* Tax Gains -Since dividends are taxed at higher rate than capital gains companies prefer buyback to reward their investors instead of distributing cash dividends, as capital gains tax is generally lower. At present, short-term capital gains are taxed at 10% and long-term capital gains are not taxed. 

* Market perception- By buying their shares at a price higher than prevailing market price company signals that its share valuation should be higher. Eg: In October 1987 stock prices in US started crashing. Expecting further fall many companies like Citigroup, IBM et al have come out with buyback offers worth billions of dollars at prices higher than the prevailing rates thus stemming the fall. 

Recently the prices of RIL and REL have not fallen, as expected, despite the spat between the promoters. This is mainly attributed to the buyback offer made at higher prices.

* Exit option -If a company wants to exit a particular country or wants to close the company. 

* Escape monitoring of accounts and legal controls- If a company wants to avoid the regulations of the market regulator by delisting. They avoid any public scrutiny of its books of accounts. 

* Show rosier financials- Companies try to use buyback method to show better financial ratios. For eg. When a company uses its cash to buy stock, it reduces outstanding shares and also the assets on the balance sheet (because cash is an asset). Thus, return on assets (ROA) actually increases with reduction in assets, and return on equity (ROE) increases as there is less outstanding equity. If the company earnings are identical before and after the buyback earnings per share (EPS) and the P/E ratio would look better even though earnings did not improve. Since investors carefully scrutinize only EPS and P/E figures, an improvement could jump-start the stock. For this strategy to work in the long term, the stock should truly be undervalued. 

* Increase promoter's stake -Some company’s buyback stock to contain the dilution in promoter holding, EPS and reduction in prices arising out of the exercise of ESOPs issued to employees. Any such exercising leads to increase in outstanding shares and to drop in prices. This also gives scope to takeover bids as the share of promoters dilutes. Eg. Technology companies which have issued ESOPs during dot-com boom in 2000-01 have to buyback after exercise of the same. However the logic of buying back stock to protect from hostile takeovers seem not logical. It may be noted that one of the risks of public listing is welcoming hostile takeovers. This is one method of market disciplining the management. Though this type of buyback is touted as protecting over-all interests of the shareholders, it is true only when management is considered as efficient and working in the interests of the shareholders. 

* Generally the intention is mix of any of the above

* Sometimes Governments nationalize the companies by taking over it and then compensates the shareholders by buying back their shares at a predetermined price. Eg. Reserve Bank of India in 1949 by buying back the shares.

Objectives of Buy Back: Shares may be bought back by the company on account of one or more of the following reasons
i. To increase promoters holding
ii. Increase earning per share
iii. Rationalise the capital structure by writing off capital not represented by available assets. 
iv. Support share value
v. To thwart takeover bid
vi. To pay surplus cash not required by business
Infact the best strategy to maintain the share price in a bear run is to buy back the shares from the open market at a premium over the prevailing market price.

Resources of Buy Back
A Company can purchase its own shares from 
(i) free reserves; Where a company purchases its own shares out of free reserves, then a sum equal to the nominal value of the share so purchased shall be transferred to the capital redemption reserve and details of such transfer shall be disclosed in the balance-sheet or
(ii) securities premium account; or 
(iii) proceeds of any shares or other specified securities. A Company cannot buy back its shares or other specified securities out of the proceeds of an earlier issue of the same kind of shares or specified securities.

Conditions of Buy Back 

(a) The buy-back is authorised by the Articles of association of the Company.

(b) A special resolution has been passed in the general meeting of the company authorising the buy-back. In the case of a listed company, this approval is required by means of a postal ballot. Also, the shares for buy back should be free from lock in period/non transferability.The buy back can be made by a Board resolution If the quantity of buyback is or less than ten percent of the paid up capital and free reserves;

(c) The buy-back is of less than twenty-five per cent of the total paid-up capital and fee reserves of the company and that the buy-back of equity shares in any financial year shall not exceed twenty-five per cent of its total paid-up equity capital in that financial year;

(d) The ratio of the debt owed by the company is not more than twice the capital and its free reserves after such buy-back;

(e) There has been no default in any of the following
i. in repayment of deposit or interest payable thereon.
ii. Redemption of debentures, or preference shares .
iii. Payment of dividend, if declared, to all shareholders within the stipulated time of 30 days from the date of declaration of dividend o.
iv. Repayment of any term loan or interest payable thereon to any financial institution or bank.

(f) There has been no default in complying with the provisions of filing of Annual Return, Payment of Dividend, and form and contents of Annual Accounts.

(g) All the shares or other specified securities for buy-back are fully paid-up.

(h) The buy-back of the shares or other specified securities listed on any recognised stock exchange shall be in accordance with the regulations made by the Securities and Exchange Board of India in this behalf.

(i) The buy-back in respect of shares or other specified securities of private and closely held companies is in accordance with the guidelines as may be prescribed.

Disclosures in the explanatory statement
The notice of the meeting at which special resolution is proposed to be passed shall be accompanied by an explanatory statement stating - 
(a) a full and complete disclosure of all material facts; 
(b) the necessity for the buy-back; 
(c) the class of security intended to be purchased under the buy-back; 
(d) the amount to be invested under the buy-back; and 
(e) the time-limit for completion of buy-back

Sources from where the shares will be purchased 
The securities can be bought back from 
(a) existing security-holders on a proportionate basis;
Buyback of shares may be made by a tender offer through a letter of offer from the holders of shares of the company or 
(b) the open market through
(i). book building process;
(ii) stock exchanges or
(c) odd lots, that is to say, where the lot of securities of a public company, whose shares are listed on a recognized stock exchange, is smaller than such marketable lot, as may be specified by the stock exchange; or
(d) purchasing the securities issued to employees of the company pursuant to a scheme of stock option or sweat equity.

Register of securities bought back
After completion of buyback, a company shall maintain a register of the securities/shares so bought and enter therein the following particulars
a. the consideration paid for the securities bought-back,
b. the date of cancellation of securities,
c. the date of extinguishing and physically destroying of securities and 
d. such other particulars as may be prescribed
Where a company buys-back its own securities, it shall extinguish and physically destroy the securities so bought-back within seven days of the last date of completion of buy-back.

Issue of further shares after Buy back
Every buy-back shall be completed within twelve months from the date of passing the special resolution or Board resolution as the case may be.
A company which has bought back any security cannot make any issue of the same kind of securities in any manner whether by way of public issue, rights issue up to six months from the date of completion of buy back.

Filing of return with the Regulator
A Company shall, after the completion of the buy-back file with the Registrar and the Securities and Exchange Board of India, a return in form 4 C containing such particulars relating to the buy-back within thirty days of such completion. 
No return shall be filed with the Securities and Exchange Board of India by an unlisted company.

Prohibition of Buy Back
A company shall not directly or indirectly purchase its own shares or other specified securities - 
(a) through any subsidiary company including its own subsidiary companies.
(b) through any investment company or group of investment companies.

Procedure for buy back
 

• Where a company proposes to buy back its shares, it shall, after passing of the special/Board resolution make a public announcement at least one English National Daily, one Hindi National daily and Regional Language Daily at the place where the registered office of the company is situated.
   
• The public announcement shall specify a date, which shall be "specified date" for the purpose of determining the names of shareholders to whom the letter of offer has to be sent.
   
• A public notice shall be given containing disclosures as specified in Schedule I of the SEBI regulations.
• A draft letter of offer shall be filed with SEBI through a merchant Banker. The letter of offer shall then be dispatched to the members of the company.
• A copy of the Board resolution authorizing the buyback shall be filed with the SEBI and stock exchanges.
• The date of opening of the offer shall not be earlier than seven days or later than 30 days after the specified date
   
• The buyback offer shall remain open for a period of not less than 15 days and not more than 30 days.
  h. A company opting for buy back through the public offer or tender offer shall open an escrow Account.

Valuation of buyback:

There are two ways companies determine the buyback price.

1.They use the average closing price (which is a weighted average for volume) for a period immediately before to the buyback announcement. Based on the trend and value a buyback price is decided

2.Shareholders are invited to sell some or all of their shares within a set price range. The low point of the range is at a discount to the market price, while the top of the price range is set at a premium to the market price. Investors are given more say in the buyback price than in the above arrangement. Still this method is rarely used. Generally, the price is fixed at a mark up over and above the average price of the last 12-18 months.

Any manipulations? 

* Some companies come out with a scheme of buyback wherein, unless the shareholders rejected the offer specifically, in response to the offer letter sent by the company, they would be deemed to have accepted it. Though courts have upheld the action of the companies, it is to be noted that small shareholders generally do not bother to read such letters and respond to the same, and may not understand the complex legal language used in such letters. 

* Some companies make it compulsory for shareholders to sell at a specified price mandated by the company. A shareholder enters a company by choice and mutual agreement and should be entitled to exit only by choice. Forcible buyback of shares at a non-transparent price would be expropriation and should be prevented. Note: GoI's budget of FY 2002-03 has relaxed buyback rules for the companies by which buyback of shares up to 10% of paid-up capital does not require shareholders approval thus putting the minority shareholders at the mercy of majority shareholders and promoters.

Eg. MNCs listed on exchanges have taken this route in a big way in 2001-2003

Checklist for investors before accepting the company's buyback offer: 
 

* Take a look at the share price movement immediately before the buyback. If there was a significant rise, the prima facie assumption is that the promoters have been up to tricks.

* Debt-equity ratio: The companies are hugely under debts are unlikely to have free cash.

* Companies that have just come to the capital markets to raise money are unlikely to be good candidates for buyback.

* When the management has passed special resolutions, with a lot of publicity, empowering the Board to buy back whenever allowed, there is enough scope for suspicion. Anybody with the genuine intention of buying back to enhance shareholders' wealth would try to do so with minimum publicity so that the share price does not flare up due to speculators.

Effect of buybacks on stock exchanges:

Buyback may leads to abnormal increase of prices posing heavy risk to those who value shares based on fundamentals. This may also lead to reduction in investor interest in the market particularly with de-listing of good shares. Eg: It was feared in 2001-03 that de-listing by many MNCs may drop the money flow to stock exchanges.

ADVANTAGES AND DISADVANTAGES OF BUYBACK OF SHARES

Advantages-

·        Increase confidence in management: It might enhance the confidence of its investors on the company’s board of directors, as these investors know that the directors are ever willing to return surplus cash if it’s not able to earn above the company’s alternative investment or cost of capital.

·         Enhances shareholders value: Generally, share buybacks are good for shareholders. The laws of supply and demand would suggest that with fewer shares on the market, the share price would tend to rise. Although the company will see a fall in profits because it will no longer receive interest on the cash, this is more than made up for by the reduction in the number of shares.

·        Higher Share Price: Buying back stock means that the company earnings are now split among fewer shares, meaning higher earnings per share (EPS). Theoretically, higher earnings per share should command a higher stock price which is great!

·        Reduce takeover chances: Buying back stock uses up excess cash. The returns on excess cash in money market accounts can drag down overall company performance. Cash rich companies are also very attractive takeover targets. Buying back stock allows the company to earn a better return on excess cash and keep itself from becoming a takeover target.

·        Increase ROE: Buying back stock can increase the return on equity (ROE). This effect is greater the more undervalued the shares are when they are repurchased. If shares are undervalued, this may be the most profitable course of action for the company.

·        Psychological Effect: When a company purchases its own stock it is essentially telling the market that they think that the company’s stock is undervalued. This can have a psychological effect on the market.

·        Buying back stock allows a company to pass on extra cash to shareholders without raising the dividend. If the cash is temporary in nature it may prove more beneficial to pass on value to shareholders through buybacks rather than raising the dividend.

·        Excellent Tool For Financial Reengineering: In the case of profit making, high dividend-paying companies whose share prices are languishing, buybacks can actually boost their bottom lines since dividends attract taxes. A buyback and the subsequent neutralisation of shares, can reduce dividend outflows, and if the opportunity cost of funds used is lower than the dividend savings, the company can laugh all the way to the bank.

·        Tax Implication: Exemption is available only if the shares are sold on a recognised stock exchange and if securities transaction tax (STT) on the sale has been paid. In a buyback scheme, neither does the sale take place on a recognised exchange nor is the STT paid. So, you will have to pay income tax on your long-term capital gain on the buyback after deducting the acquisition cost of your shares plus the benefit of indexation from the year of purchase to the year of buyback. On the resultant gain, the tax would be 20 per cent plus the applicable surcharge, if any, plus 2 per cent education cess. You may also work out the tax at 10 per cent of the gain without considering indexation. Your tax liability will be limited to the lower of the two calculations.

·        Stock buybacks also raise the demand for the stock on the open market. This point is rather self explanatory as the company is competing against other investors to purchase shares of its own stock.

Disadvantages:

• Sending Negative Signals: A buyback announcement can send a negative signal in these situations. A typical example is the HP case: From November 1998 through October 2000, the computer giant Hewlett-Packard spent $8.2 billion to buy back 128 million of  its shares. The aim was to make opportunistic purchases of HP stock at attractive prices—in other words, at prices they felt undervalued the company. Instead of signaling a good operating prospects to the market, the buyback signal was completely drowned out more powerful contradictory signals about the company’s future which are an aborted acquisition, a protracted business restructuring, slipping financial results, and a decay in the general profitability of key markets. By last January, HP’s shares were trading at around half the average $64 per share paid to repurchase the stock.

• Backfire: Buybacks can also backfire for a company competing in a high-growth industry because they may be read as an admission that the company has few important new opportunities on which to otherwise spend its money. In such cases, long-term investors will respond to a buyback announcement by selling the company’s shares.

• The share buyback scheme might become a big disadvantage to the company when it pays too much for its own shares. Indeed, it is foolish to buy in an overpriced market. Instead, the company should put the money into assets that can be easily converted back into cash. This way, when the market swings the other way and is trading below its true value, shares of the company can be bought back at a discount, ensuring current shareholders receive maximum benefit. Strictly, a company should repurchase its shares only when its stock is trading below its expected value and when no better investment opportunities are available.

Example of what happens after buyback ?

Company B Ltd,

Explanation

Return on Assets: We can see that ROA has increased after buyback. The reason behind this increase is that there is a reduction in the total assets. Total assets have gone down from Rs.10, 000 to Rs.9625, income remaining same.

Return on Equity: It has also increased from 0.88% to 1.13%. This is due to decrease in the shareholder’s equity, which has gone down from Rs.1500 to Rs.1250.

Earning Per Share:It has also increased from Rs.10 to Rs.12. The reason behind the increase of EPS is that the numbers of shares have reduced from 150 to 125, causing EPS ratio to increase.

Price – Earning Ratio: Here market value of the share has increased from Rs.10 to Rs.15, which is a 50% hike in the price. On the other hand EPS has also increased from 10 to 12, which is a 20% hike. Since the overall increase in the market value of the share is much more than the increase of EPS. Therefore we can see an increase in the price-earning ratio.

IMPROVEMENT IN THE FINANCIAL RATIOS OF THE COMPANY

When a company decides to go for buyback it has a huge impact on the financial ratios of the company. The impact is more on the positive side.

There are four majors Ratios which gets impacted due to buyback. They are as follows:

Return on Assets:             ROA = Net Income / Total Assets

Return on Equity:             ROE = Net Income / Shareholder’s Equity

Earning per Share:            EPS = profit after tax / number of shares

Price Earning Ratio:         P/E ratio = market value of share / EPS

CASE STUDY: STERLITE INDUSTRIES
 

Sterlite Industries (India) Ltd (SIIL) is a leading producer of copper in India. It is the principal subsidiary of the Vedanta Resources Group a London listed metals and mining major with Aluminum, Copper and Zinc operations in India and Australia,. Sterlite was the first company in India to set up a Copper Smelter and Refinery in Private Sector and operate the largest capacity continuous Cast Copper Rod plants. SIIL’s main products, Copper Cathodes and Copper Rods meet global quality benchmarks.

In 2001, Homegrown metals major Sterlite Industries made an offer to its non-promoter shareholders to buy back their holdings UNDER a scheme of arrangement (approved by the Mumbai High Court), Sterlite Industries proposes to purchase around 2.79 crores equity shares (representing approximately 50 per cent of the paid-up equity) from the shareholders.

The following arrangement was made for the same:

• The consideration for the purchase is payable in two parts : a) a cash consideration of Rs 100 and b) five debentures of the face value of Rs 10 each. These are secured non-convertible debentures with a coupon rate of 10 per cent and redeemable at the end of the fourth, fifth and sixth year from the date of allotment.
   
• Unlike an open offer or buyback, in this scheme of arrangement, if the shareholder chooses to remain a shareholder of Sterlite, he must intimate to the company his intention to continue to hold equity shares. This has to be done by exercising his option using an option form provided for the purpose, which has to be sent to Sterlite by June 21, 2002.

• If the public shareholding is reduced below 10 per cent, Sterlite Industries will apply for delisting of the shares from the stock exchanges.

This arrangement of buyback met with a lot of uproar from SEBI as well as the investors with respect to legalities.

Charges against Sterlite

The Securities and Exchange Board of India (Sebi) moved the Mumbai high court for a stay of Sterlite’s buyback offer. A move without precedent, it follows a furor over the terms of the Sterlite open offer.

It said that Sterlite had violated the Companies Act Provisions, 391 & 77 (a) and that the scheme also violated the Depositories Act under which shareholders' share could not be cancelled without their consent.

1. Legal hindrance: The company had formulated the scheme under Section 391-394 of the Companies Act, 1956, even while there is an existing provision in the Companies Act, Section 77A, that provides for buyback. Hence, it was believed that the company had left some grey areas, legally speaking.

2.      Procedural hindrance: Generally a company that wants to buy-back shares makes the offer to the shareholders who tender their shares to the registrars if they want to sell their holdings.  Once the tender of shares is done the registrar (after considering over subscription, if any) will send the cheque for the accepted shares and the unaccepted shares,if.any.

But instead of following this method Sterlite sent cheques in advance to the shareholders with a form for non-acceptance of the offer which they could fill in, sign and send to the company along with the cheque if they did not want to sell their holdings. Shareholders have to communicate their non-acceptance of the offer to the company. And silence would be construed as an acceptance of the offer. The scheme provided that unless the shareholders rejected the offer specifically they would be deemed to have accepted it. Thus, if, for instance, you missed reading the notice or forgot to send a letter of rejection, you will find a cheque in the mail soon thereafter and your shares bought and cancelled.
This procedure, termed negative consent is a little confusing to the investors because they would be inclined to believe that acceptance is mandatory because cheques are sent even before they tender their share.

Judgment:

The Court in its judgment declared that Section 391 of the Companies Act, 1956 could govern Sterlite's buyback scheme is distinctly independent of Section 77A of the Companies Act, 1956. “The legislative intention behind the introduction of section 77A is to provide an alternative method by which a company may buy back up to 25 per cent. Of its total paid up equity capital in any financial year. It does not replace or take away any part of the pre-existing jurisdiction of the company court to sanction a scheme for such reduction under sections 100 to 104 and section 391.”

BIBLIOGRAPHY

a. A. Ramaiya, COMPANIES ACT

b. A.k. Majumdar, COMPANY LAW AND PRACTICE

c. K. M. Ghosh & Dr. K.R. Chandratre’s Company Law