Capital restructuring via buy-back of shares

February 14, 2015 by Neerja Gurnani Leave a Comment

Sanchit Srivastava, Dr. Ram Manohar Lohiya National Law University
Editors 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 companys 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 firms 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 companys 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 companys 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.
3. 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]
4. 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]
5. 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.
6. 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.
7. 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 corporations 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 boards
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 companys 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 & Assns 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.