Buy Back of Securities- An Analysis

Share capital is a very essential part of a company, listed or unlisted. 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 with the introduction of section 77A, 77AA, and 77B in the Companies Act, 1956 the shareholder can realize the price by selling directly to the company .

Buy Back of Securities
In general terms 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. 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.

Legislative History
Under Section 77 of the Companies Act, 1956, a limited company is prohibited from buying back its own shares. The basic reason for such a prohibition was a feeling that allowing companies to buy-back their shares could give rise to companies ‘trafficking’ in their own shares leading to undesirable practices in the stock market, like insider trading or other such unhealthy influences on stock prices . There was also an apprehensions that introduction of buy-back was unlikely to improve the stock market climate, but on the contrary worsen the climate as buy-back would in all likelihood facilitate more manipulation This general prohibition has been diluted by the statute, which permits a company to buy-back its securities after following the procedural safeguards provided in Section 77A, 77AA and 77B of the Companies Act.

Prior to the Amendment of the Companies Act in 1999, the laws as to the buying of its share by the companies were very stringent. 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).

In 1887, in was held in the case of Trevor v. Whitworth , that a company limited by shares may not purchase its own shares as this would amount to an unauthorized reduction of capital. The rationale for this decision was that though the creditors of the company make decisions about its credit-worthiness on several grounds, but an important ground is the amount of its share capital. If the courts had not established at an early stage that capital was ‘sacrosanct’ and could not be returned to shareholders at their whim, then share capital would not have been protected. Without this protection, creditors could find shareholders depleting share capital, with creditors left to carry all the business risks.

In India, the rule in Trevor v. Whitworth was enshrined in Section 77 of the Companies Act, 1956 which prohibited a company limited by shares, or by guarantee, and having a share capital from buying or canceling its own shares, nor may a company do so indirectly, by getting another person to buy the shares on its behalf, unless it complied with the provisions and followed the procedure for reduction of share capital under Sections 100 to 104 of the Companies Act, 1956 which involved sanction by the Court. Thus, by implication, an unlimited company can purchase its own shares. Article 3(e) of Table E, Schedule 1 to the Act gives power to such companies to reduce its shares in any way . Similarly, forfeiture for non-payment of calls and valid surrender do not involve purchase of shares by the company . Any valuable consideration paid out of the company’s assets amounts to a transaction of purchase .

A prohibition on the buy-back of shares thus existed by virtue of Section 77 of the Companies Act, 1956 under which a buy-back could be made only by reduction of share capital. 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.

In the words of the working group which recommended the introduction of buy back in the companies act:
“It is an erroneous belief that the sole reason for buy back is to block hostile take-over. In this connection it is pertinent to list five reasons why the bank of England favoured the making of law to allow companies to repurchase their shares of which blocking take-over was only one:
• To return surplus cash to shareholders
• To increase the underlying share value
• To support the share prices during temporary weakness.
• To achieve or maintain a target capital structure.
• To prevent or inhibit unwelcome take-over bids.
Briefly a company resorting to the buy-back may have surplus cash, and it may not have found the right avenue to invest such surplus cash, during such period of dilemma the company may decide to return the surplus cash by buying back its shares, with a hope that at a later time when the company brings on an expansion the investors do not loose their faith in the company. Secondly the company might as well think of buying its shares with a view to increase the value of the shares which after the process of buy back still remain in the market. For after the shares are bought back the number of marketable shares become less and thus the prices increase. Thirdly, at times there is a slump in the share market due to no fault of the company. Though the slouch may be temporary but may have continued far too long .The management then may decide to give value to the shareholders and buy back their shares at a price higher than the market price. This is generally done to instill faith in the minds of the shareholders. Saving a company from hostile take-over has always been seen as a major force behind bringing about this amendment, the company may use the surplus cash available in buying back its shares and bringing the number of floating shares down, resulting in the suitor not finding it a worthy investment or a profitable acquisition. These could be certain reasons why a company may resort to buy back of its shares.

Thus in short, shares may be bought back by the company on account of one or more of the following reasons:
• To increase promoters holding;
• Increase earnings per share;
• To improve return on capital return on net worth and to enhance the term shareholder value;
• To provide an additional exit route to the shareholders when shares are undervalued or are thinly traded;
• To enhance consolidation of stake in the company;
• To return surplus cash to the shareholders;
• To achieve optimum capital structure;
• Rationalize the capital structure by writing off capital not represented by available assets;
• Support share value;
• To thwart hostile takeover;
• To pay surplus cash not required by business.
The buy-back of shares or securities may be in any one or more of the following modes:
• existing security-holders on a proportionate basis(tender offer method);
• the open market through:
o book building process in accordance with Regulation 17;
o stock exchanges in accordance with Regulation 15; or
• 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
• the securities issued to employees of the company pursuant to a scheme of stock option or sweat equity.
No company shall directly or indirectly purchase its own shares or other specified securities :
• Through any subsidiary company including its own subsidiary company; or
• Through any investment companies or group of investment companies; or
• If a default, by the company, has been made in respect of:
o Repayment of deposit or interest payable thereon, or
o Redemption of debentures or preference shares, or
o Payment of dividend to any share holder, or
o Repayment of any term loan, or
o Interest payable thereon to any financial institution or bank.
• If the company has not complied with the provisions of section 159, 207 and 211 of the Act.
Moreover, a listed company is prohibited from buying back its securities through negotiated deals, spot transactions, private arrangements and insider dealings .

The Act provides that buy-back of shares can be financed only out of -
• 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 is required to be transferred to the capital redemption reserve and details of such transfer should be disclosed in the balance-sheet; or
• securities premium account; or
• Proceeds of any shares or other specified securities.
It is provided that no buy back of any kind of shares or other specifies securities can be made out of the proceeds of the same kind of shares or same kind of other securities as it will frustrate the purpose sought to be achieved by an issue and will make no sense. It can however be used for buy-back of another kind of security.

The Companies Act provides that a company can buy-back its shares only when :
• It must be authorised by the articles of association of the company. It is, therefore, necessary for a company proposing to resort to a buy-back to make sure that such an authority exists in its articles. If the articles do not contain such a provision, the company must follow the procedure laid down in Section 31 of the Companies Act for altering its articles to incorporate such a provision by passing a special resolution and filing a certified true copy of the same along with Form No. 23, with the concerned Registrar of Companies, for registration as required by Section 192 of the Act.
• A special resolution has been passed in general meeting of the company authorizing the buy-back;
However, the said special resolution shall not be required to be passed if the following conditions are satisfied :
o The buy-back is or for less than 10% of the total paid up equity capital and free reserves of the company, and
o A resolution authorizing the buy-back is passed at the meeting of the board.
Provided that no company can come out with a fresh proposal to buy back its shares within a period of 365 days from the date of the preceding offer of buy-back.
• The ratio of the debt owed by the company is not more than twice the capital and its free reserves after such buy-back:
Provided that the Central Government is empowered to relax the debt-equity ratio in respect of a class of companies but not in respect of any particular company .
• The impugned shares/securities must be fully paid-up.
• The buy-back of the shares or other specified securities listed on any recognized stock exchange is in accordance with the SEBI (Buy-back of Securities) Regulations, 1998.
• The buy-back in respect of shares or other specified securities other than those listed on any recognized stock exchange shall additionally comply with the provisions of the Private Limited Company and Unlisted Public Company (Buy-back of Securities) Rules, 1999.
The explanatory statement accompanying the notice convening the general meeting at which the special resolution will be passed should contain all the relevant particulars of the buy-back such as:
• All material facts, fully and completely disclosed:
• The necessity for buy-back;
• The class of security intended to be purchased by the buy-back;
• The amount to be invested under buy-back;
• The time limit for completion of buy-back.
• The company is also required to pass a special resolution in its general meeting after following the procedure laid down in section 171, 172 and 173.
Every buy-back is required to be completed within 12 months from the date of passing the special resolution or the Board resolution, as the case may be or where the resolution is passed through postal ballot, the date of declaration of the result of the postal ballot, as the case may be.
• Declaration of Solvency- A declaration of solvency is required to be filed by the company with the Registrar and SEBI in the prescribed form before the buy-back is implemented to guaranty its solvency for at least a year after the completion of buy-back . It should be verified by an affidavit and signed by two directors, one of whom must be the Managing Director, where there is one. However, a company whose shares are not listed on the Stock Exchange is not required to file this declaration with SEBI.
• Physically Extinguishment of Securities- A Company after the completion of buy-back is required to physically extinguish and destroy its securities within 7 days of the last day on which the buy-back process is completed .
• Prohibition on Further Issue of Shares- A Company buying back its securities is prohibited from making a further issue of securities within a period of 6 months except by way of a bonus issue and discharge its existing obligations such as conversion of warrants, stock option schemes, sweat equity or conversion of preference shares or debentures into equity shares .
• Register of Securities Bought Back- A Company is also required to maintain a register containing the particulars of the brought back securities, including the consideration paid for them, the date of cancellation, the date of physically extinguishing and physically destroying securities and such other particulars as may be prescribed . Such particulars are required to be entered in the register of buy-back of securities within 7 days of the date of completion of buy-back.
• Filing of Return- On completion of the buy-back process, the company shall within a period of 30 days file with SEBI and the Registrar a return in e-form No. 4C containing the particulars prescribed. A private company and a public company whose shares are not listed on a recognized stock exchange should file the return of buy-back with the Registrar only .
The conditions specified below are applicable to only buy-back of shares effected under the said provisions and the conditions applicable to Sections 100, 104, 391 cannot be applied to buy back of securities .
Where a Company purchases its own shares out of free reserves, then a sum equal to nominal value of the shares so purchased has to be transferred to the Capital Redemption Reserve Account referred to in clause (d) of the proviso to sub section (f) 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 shares. Further, the Central Government may, from time to time notify other securities as specified securities and such notified securities may not be shares.
If a company makes default in complying with the provisions, the company or any officer of the company who is in default shall be punishable with imprisonment for a term which may extend to two years, or with fine which may extend to fifty thousand rupees, or with both. The offences are compoundable under section 621A of the Companies Act, 1956.
This scheme is advantageous to the Companies as:
• Companies may buy-back its shares to take advantage of low share prices and hope that their value will rise quickly.
• Companies considering that its share price has been unfairly lowered buy-back them to give the price a boost.
• 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.
• A company could be taking advantage of the lower price to infuse its employee stock option program.
• A company may buy-back it shares to safeguard itself from hostile takeover bids.
However, there are certain drawbacks and areas of concern in the legislation:
• 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.
• 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.
• 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.
• There is no restriction on repeated buy-backs year after year, which has resulted in increasing promoters equity stake ultimately.
• 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.
• There are reports of insider trading in some of the cases before the buy-backs are announced.
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. If one takes a peek at the web-site of the SEBI, every month on average 2-3 companies make public announcements for buy-back of shares. 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 fulfillment of long-standing demand towards liberalization of company law.

• Dr. Avtar Singh : Company Law, Eastern Book Company
• A.K. Mujumdar : Company Law, Kalyani Publishers
• Palmer : Company Law (Vol 1), Steven & Sons Ltd., London
• Young Patrick : Capital Market Revolution: The Future of Markets in an Online World
• H.K. Saharay : Company Law, Universal Law Publishing Co.
• Taxman : SEBI Manual
• Sanjeev Aggarwal : Guide to Indian Capital Market, Bharat Law House

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