National Law Institute University,Bhopal

A Project Of Law of Business Association-II OnBuy Back of Shares

Submitted to:-Submitted by:-Asso. Prof. (Dr.) Kondaiah J. Harkiran Singh ChimaRoll No. - 2011 B.A. LL.B. 24Enrollment No. A-1072VIII TrimesterIII Year

TABLE OF CONTENTS

1Introduction32Understanding the Concept32.1Conceptual Conundrum32.2Methods of buy-back33Law Governing Repurchase Of Shares In India43.1Introduction43.2Rationale behind Section 7743.3Objectives Of A Buy-back53.4Resources of Buy-back53.5Conditions of Buy-back63.6Sources from where the Shares can be purchased63.7Procedure74Law Governing Repurchase Under English Law85Law governing Repurchase under U.S. Law86The Debate: Pros and Cons97Conclusion118Bibliography13

IntroductionThe issue of a company buying back its shares[footnoteRef:1] has moved beyond the realm of abstract discussion among academicians and into the real world of corporate controversies. The endeavour should be to provide one with an overview of the concept of buy-back of shares, the ensuing debate and some recommendations. [1: Hereinafter repurchase of shares.]

Understanding the ConceptIn law, a company being a separate legal personality is capable of buying and holding property in its own name. a corollary to this privilege would be that a company could buy its own shares, shares being considered in all legal regimes as property.[footnoteRef:2] [2: Under Section 82 of the Companies Act, 1956, shares are movable property.]

Conceptual ConundrumIt is clear that conceptually, repurchase of shares runs counter to the age-old concept of separate legal personality. A companys incorporating gives it a legal personality distinct from its shareholders. So, traditionally it was thought that repurchase of its own shares would negate that very distinction since a company would then become its own shareholder. But, modern times have witnessed a structural change in the theme and philosophy of Company Law that, subject to the restrictions envisaged under it, a company may buy-back its own shares.Methods of buy-backTwo situations can result on a repurchase of shares. In the first situation, the shares repurchased will remain as assets of the company. The term commonly used for these shares is treasury stock.[footnoteRef:3] On the balance sheet, the share capital on the liabilities side will remain unaffected except that a part of share capital repurchased by the company would represent a liability owed by the company to itself. [3: This term is used for repurchased shares in the Model Business Corporation Act in USA (1971 Version).]

In the second situation, the repurchase of shares would be concomitant with the reduction of share capital to some extent. In this situation, there would be an extinguishment of the shares bought by the company. The shares repurchased thus do not remain as assets of the company.The crucial difference between the two situations is that while in the former case, the shares repurchased are held by the company as its property and can be resold later, in the latter case, the shares repurchased are extinguished and thus remain out of circulation.Law Governing Repurchase Of Shares In IndiaIntroductionThe provisions regulating buy-back of shares are contained in Section 77-A, 77-AA and 77-B 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 Securitites) 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(f) and (g) respectively. Section 77-A of the Companies Act, 1956 permits the companies to buy-back its own securities except in certain circumstances.[footnoteRef:4] [4: Refer s. 77BProhibiotn for Buy-Back in Certain Circumstances]

Rationale behind Section 77Section 77 is a crystallization of a catena of English decisions starting from the well-known decision of the House of Lords in Trevor v. Whitworth[footnoteRef:5]. A summary of this decision would suffice to understand the rationale behind section 77. The House of Lords struck down the purchase of its own shares by a company even though it was authorized by the Companys articles for the following reasons:[footnoteRef:6] [5: (1882) 12 A.C. 409. This is no longer the law in England.] [6: Buckley on the Company Acts (London: buttersworth & Co., 1949) 243.]

1. Purchase of its own shares is reduction of capital. The Act[footnoteRef:7] in sanctioning reduction of capital under certain conditions and with certain safeguards impliedly prohibits it unless these conditions and safeguards are complied with. [7: The English Companies Act]

2. The Act impliedly prohibits the return of capital to its members. Purchasing its own shares would in effect mean returning the capital to its members.3. The transaction cannot be justified as incidental to the companys objects. The creditors interests are paramount.The question that arises is as to why so much emphasis is laid on maintenance of capital by the company. The answer lies in an important consequence of incorporation of a company limited by shares. An incorporated body is different from a sole proprietorship or partnership in the sense that in these businesses, personal assets can be used to satisfy the claim of creditors. Therefore, capital maintenance is not an important requirement. But in the case of a company limited by shares, the absence of personal liability of its members necessitates the maintenance of capital in the interest of creditors, since a repurchase of shares would result in reduction of capital. This is prohibited except under certain circumstances. An unlimited company is exempted from section 77 on the same logic as that which applies to sole proprietorship and partnerships.[footnoteRef:8] [8: Barc and Bower ed., Tolleys Company Law (London: Tolley Publication Co. Ltd., 1988) 1096.]

Objectives Of A Buy-back1. To increase promoters holding1. Increasing earnings per share1. Rationalize the capital structure by writing off capital not represented by available assets.1. Support share value1. To thwart takeover bid

1. To pay surplus cash not required by business1. In fact 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[footnoteRef:9] [9: Section 77A(1)]

A Company can purchase its own shares from:1. 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; or1. Securities Premium Account; or1. Proceeds of any shares or other specified securities: A company cannot buy-back its shares or other specified securities out of the proceeds of earlier issue of the same kind of shares or specified securities.Conditions of Buy-back[footnoteRef:10] [10: S.77A (2)]

1. The buy-back is authorized by the Articles of Association of the company;[footnoteRef:11] [11: M.D.jindal v. Hydro S. and S. Industries Ltd., [2009] 148 CompCas 719 (CLB]

1. A special resolution has been passed in the general meeting of the shareholders[footnoteRef:12] authorizing 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 is not more than 10% of the paid up capital and free reserves. [12: In Re Gujarat Amiya Exports Ltd., (2004) 118 CompCas 265 Guj.]

1. The buy-back should of less than 25% of the total paid up capital and free reserves of the company and that the buy-back of equity shares in any financial year shall not exceed 25% of its total paid up equity capital in that financial year;1. The ratio of the debt owed by the company is not more than twice the capital and its free reserves after such buy-back;1. All the shares or other specified securities for buy-back are fully paid-up;1. 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;1. There has been no default in any of the following:[footnoteRef:13] [13: S.77B(1) (c)]

0. In repayment of deposit or interest payable thereon,0. Redemption of debentures or preference shares, or0. Payment of dividend, if declared to all shareholders within the stipulated time of 30 days from the date of declaration of dividend or0. Repayment of any term loan or interest payable thereon to any financial institution or bank;Sources from where the Shares can be purchased[footnoteRef:14] [14: S.77A(5)]

The securities can be brought back from1. Existing security-holders on a proportionate basis; Buy-back of shares may be made by a tender offer through a letter of offer from holders of shares of the company; or1. The open market throughbook building process or stock exchanges; or

1. 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; or1. Purchasing the securities issued to employees of the company pursuant to a scheme of stock option or sweat equity.[footnoteRef:15] [15: For meaning of Sweat Equity, see S.79A.]

Procedure1. Where a company proposes to buy-back its shares, it shall after passing of the special/board resolution make a public announcement in at least one English national daily, one Hindi national Daily and Regional Language Daily Newspaper at the place where the registered office of the company is situated.[footnoteRef:16] [16: In RE: Shalibhadra Inforsec Ltd., SEBI, MANU/SB/0050/2008]

1. 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.1. A public notice shall be given containing disclosures as specified in Schedule I of the SEBI regulations.1. 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.[footnoteRef:17] [17: S. Arunachalam v. Sugavaneswara Spinning mills Pvt. Ltd., [2008] 142 CompCas 611]

1. A copy of the Board Resolution authorizing the buy-back shall be filed with the SEBI and stock exchanges.[footnoteRef:18] [18: S.77A(6)]

1. The date of the opening offer shall remain open for a period of not less than 15 days and not more than 30 days.1. A company opting for buy-back through the public offer or tender offer shall open an escrow Account.1. Physical Destruction of Securities[footnoteRef:19]: where a company has bought back its securities, it has to extinguish them and physically destroy them. This should be done within 7 days of the last day on which the buy-back process is completed. [19: S.77A(7)]

1. Penalty:[footnoteRef:20] If a company makes default in complying with the provisions of Companies Act, 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. [20: S.77A (11)]

1. Issue of further shares after buy-back:[footnoteRef:21] every buy-back shall be completed within 12 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 issue of the same kind of securities in any manner whether by way of public issue or rights issue, up to 6 months from the date of completion of buy-back.[footnoteRef:22] [21: S.77A (8)] [22: Lammertz Industrienadel GmbH v. Altek Lammertz Needles Ltd., [2009] 148 CompCas 669 (CLB)]

Law Governing Repurchase Under English LawUnder English Law, substantial amendments have been made regarding purchase of shares. Section 162 of the companies Act, 1985, provides that subject to certain provisions, a company, if authorized, may

do so by its articles, and may purchase its own shares. Shares repurchased have to be cancelled and cannot be held as treasury shares by the company.[footnoteRef:23] [23: Section 162(2)]

For the purpose of repurchase, a dual classification has been made in the Act as market purchases and off market purchases.[footnoteRef:24] Under section 166, a company can make market purchase of its own shares if authorized by ordinary resolution in general meeting. The effect of these provisions is that the procedure for repurchase of shares in U.K. is not as rigorous as in India. A major distinction is the absence of courts intervention in the process of repurchase. [24: Market purchases are purchases of listed shares in the market. Otherwise it is an off-market purchase.]

Law governing Repurchase under U.S. LawThe law relating to repurchase of shares in the U.S. differs from state to state. most of the shares follow either the 1971 or 1979 version of the Model Business corporation act. In both the versions, a company has been given the general power of repurchasing its shares subject to the condition that even after such repurchase, the company must have a surplus of assets over its liabilities and stated capital.[footnoteRef:25] [25: The Solvency test.]

But the crucial difference between the two versions is that under the former, the repurchased shares are allowed to remain as treasury stock and could be resold by the company whereas in the latter, these shares are extinguished and the share capital reduced to that extent.As in India, the U.S. law lays down stringent guidelines with reference to buy-back of shares. One of the legal safeguards to prevent the company from jacking up its share prices at the time of public offer, is to prohibit it from buying back its shares within a year of capital issue. Further, the volume of shares

repurchased on any day in the capital market cannot exceed 5% of the trading volume of the shares on the particular day.[footnoteRef:26] [26: Naresh Kumar, Buying Back of Shares, SEBI & Corporate Laws Magazine, Nov. 1994:120]

The Debate: Pros and ConsWhat should be the policy approach in Indian corporate law as regards repurchase of shares? This issue assumes importance in the current economic context where in the process of gloabilsation of the Indian economy, Indian laws are expected to conform to international trends and what is euphemistically termed as new realities of the Corporate sector. This is perhaps one issue in corporate law which has generated a strong debate with views being expressed both for and against repurchase of shares by companies.The following are the reasons given in favour of repurchase of shares:1. Preventing takeover bidsThis is the reason most often given for allowing companies full freedom to repurchase their shares.[footnoteRef:27] In the liberalized environment where foreign corporate entry brings increased competition and takeover bids, it is argued that repurchase of the shares of the company would help the incumbent management to retain its control over the company. Repurchase enables this in two ways: [27: Naresh Kumar, Moving towards a Flexible Corporation The Economic Times, 11 Dec. 2006: 5]

1. The company reduces the number of shares available for purchase and consequently takeover through massive purchase of companys shares is prevented.1. Repurchase increases demand for the companys shares which has the effect of increasing the share prices which in turn acts as deterrent to massive share purchases for the purpose of takeover.

Thus, repurchase of shares has been touted as the latest remedy against takeovers of companies. There is a contrary view[footnoteRef:28] which points out that, adequate provisions have been made in the Companies Act, 1956, itself against takeovers in Section 111, Section 250 and Section 409 of the Act and in section 22A of the Securities (Contracts & Regulations) Act, 1956.[footnoteRef:29] The merits of this argument forms part of the larger discussion relating to the law on takeovers, suffice it to say that despite these provisions there is a palpable fear in corporate circles that takeovers might become the order of the day. [28: U.P. Mathur, Emerging International Laws: corporate Law Chartered Secretary Vol. XXXIV, no.4, Oct. 2008: 891.] [29: Section 111 grants power to a company (subject to an appeal to the Company Law Board) to refuse to register transfer of shares on technical grounds. Section 250 enables the CLB to prohibit the transfer of shares and debentures of a company in certain cases.]

But the utility of the aforesaid remedy is limited to only cash rich companies who have surplus funds to spare. Companies which are struggling to break even or loss making companies will remain, in practice, bereft of the remedy of repurchase of shares.1. Reduction in Dividend Outgo and EquityA repurchase reduces or saves the company from paying dividend on the sharecapital repurchased. Further, if the company decides to distribute dividend out of the same amount of appropriated profits, the remaining shareholders get an increased rate of dividend on the shares held by them. The reduction in equity benefits the other shareholders since the percentage of their holding in the company increases.[footnoteRef:30] [30: Nitish Sengupta, buyback of Shares of Companies, The Economic Time, Nov. 2, 1994, 91.]

1. Good InvestmentA company which makes good profits and whose shares are traded at a stable and high price can use its surplus funds to invest in its own shares which would be a good business investment compared to investments in other assets or shares of other companies.

But, if discussed as before, shares repurchased re extinguished and share capital is reduced to that extent, repurchased shares will no longer be a good investment since they can never be assets of the company.1. Share Prices1. Maintenance of share prices: a repurchase in times of downslide in the market help in maintaining share prices of the company.1. Increase in share prices: usually, a repurchase creates additional demand for the companys shares in the market and this jacks up its prices. Recent research in the U.S. has shown that between 1980 and 1990, a companys share prices jumped on an average 35% merely on the announcement of a share repurchase plan.[footnoteRef:31] Since purchase creates a favourable market for the shares, the high liquidity of the shares ensured which in turn benefits the investors. [31: Sanjay Bakshi, The Otherside of Share Repurchases, Economic Times, 3 Nov. 2009: 4 ]

1. Correcting undervaluation of companys shares: repurchase s the managements way of sending a message to the shareholders and investors that it believes its shares are undervalued in the market and do not reflect their intrinsic value.

The following are the reasons given against repurchase of shares:1. Creditors InterestThe law as a regulatory mechanism should always treat with respect and care, the interst of the creditors. Since a repurchase would result in a return of capital to its members, such repurchases must be prohibited. The creditor gives credit to the corporation on the basis of its capital and he is entitled to an assurance that such capital will be maintained.

1. Trafficking in Shares and Rigging of PricesA company, since it is privy to its own information will be able to buy and sell its own shares at appropriate time and thus indulge in insider trading[footnoteRef:32] solely with the object of artificially controlling the share prices. But there is a view that companies have always been manipulating prices through trading by dummy companies or investors companies in their shares. Allowing repurchase of shares will only legalise such existing practices and not create any new practice. [32: Parthasarathy, Why Companies want to buy back own shares, The Hindu, 15 Dec. 2009: 25]

ConclusionBuy-back of shares is the repurchase of outstanding shares by a company in order to reduce the number of shares on the market. Companies will buy-back its 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. A buy-back is a method for a company to invest in itself since they cant own themselves. Thus, buy-back reduces the number of shares outstanding on the market which increases the proportion of shares the company owns. The basic premise in any proposal for amendment is that the ground realities have changed and thus the legislation has to be altered accordingly. To put it in a different way, amendments make sense when the purpose for which the original section was enacted has itself become obsolete. The purpose of Section 77 was primarily to protect the interest of the creditors of the company and also to prevent the company and the management from unjustly enriching themselves by trafficking in the companys own shares. The question is whether introduction of S.77A, S.77AA and S.77B indicates that this purpose has lost its significance or is it a new wave in giving priority to companys interest over that of creditors. A period of 11 years is a short period to judge the success of a law. However, looking at all the procedural requirements introduced under the 1999 Amendment, it seems like legislature has struck balance between the afore-mentioned competing interests.

Bibliography

Books referred0. Majumdar, A.K. & Dr. G.K. Kapoor. Taxman Company Law and Practice. 12th ed. Mumbai: Taxman Allied Services Pvt. Ltd. 2009.1. Singh, Avtar. Company Law. 15th ed. Lucknow: Eastern Book, 2007..

Statutory compilation1. The Companies Act, 1956

Internet Sites1. http://www.manupatra.com1. http://www.indiankanoon.org1. http://www.law.umkc.eduvotes.com1. http://www.judic.nic.in1. http://www.courtnic.nic.in1. http://www.lawmin.nic.in

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