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Themes: Financial Markets Period : 1997 - 2002 Organization : SEBI Pub Date : 2002 Countries : India Industry : Financial Services
"MNCs are taking advantage of the depressed market conditions to mop up the shares. There is nothing legally wrong in buying back shares, but it should be by paying a fair price to minority shareholders"
- Kirit Somaiya, President, Investor Grievance Forum1.
The Buyback Option
In October 2000, Royal Philips Electronics of Netherlands (Philips), the Dutch parent of Philips India Limited, announced its first offer to buyback the shares of its Indian subsidiary. The open offer was initially made for 23% of the outstanding shares held by institutional investors, private bodies2 and the general public. The offer was made at Rs.105, a premium of 46% over the then prevailing stock market price. With this, Philips became one of the first multinational (MNCs) companies in India to offer buyback option to its shareholders. Soon after, the buyback option was offered by several multinational companies (MNCs) to increase their stake in their Indian ventures. Some of these companies were Cadbury India, Otis Elevators, Carrier Aircon, Reckitt Benkiser etc. Fund managers which held these companies' stocks felt that allowing buyback of shares was one of most favorable developments in the Indian stock markets. It provided a much needed exit option for shareholders in depressed market conditions. Buyback by the company usually indicated that the management felt that its stock was undervalued. This resulted in an increase in the price, bringing it closer to the intrinsic value and providing investors with a higher price for their investment in the company. However, critics of the buyback option claimed that large multinationals had utilized the buyback option to repurchase the entire floating stock from the market with the objective of delisting3 from the stock exchange and eliminating an investment opportunity for investors. Moreover, most MNCs that offered buyback option reported a steep decline in the trading volumes of the shares of their Indian ventures. The declining liquidity of these shares prompted critics to say that the Government of India's attempt to revive capital markets by allowing buyback of shares had failed.
The Buyback Act
The buyback ordinance was introduced by the Government of India (GOI) on October 31, 1998. The major objective of the buyback ordinance was to revive the capital markets and protect companies from hostile takeover bids.4 The buy back of shares was governed by the Securities and Exchange Board of India's (SEBI)5 Buy Back of Securities Regulation, 1998, and Securities and Exchange Board of India's (SEBI) Substantial Acquisition of Shares and Takeover Regulations, 1997. The ordinance was issued along with a set of conditions6 intended to prevent its misuse by companies and protect the interests of investors. According to guidelines issued under SEBI's Buy Back of Securities Regulation, 1998, a company could buyback its shares from existing shareholders on a proportionate basis7 : Through tender offer. • From the open market, through the book building process8 or the stock exchange. • From odd lot holders9. The ordinance allowed companies to buy back shares to the extent of 25 per cent of their paid up capital and free reserves in a financial year. The buyback had to be financed only out of the company's free reserves, securities premium account, or proceeds of any earlier issue specifically made with the purpose of buying back shares. The ordinance also prevented a company that had defaulted in the repayment of deposits, redemption of debentures or preference shares, and repayment to financial institutions from buying back its shares. Moreover, a company was not allowed to buy back its shares from any person through a negotiated deal, whether through a stock exchange, spot transactions,10 or any private arrangement. It also allowed the promoters of a company to make an open offer11 (similar to an acquisition of shares) to purchase the shares of its subsidiary. This allowed foreign promoters to utilize their surplus funds and make an open offer to acquire a 100% stake in their Indian subsidiaries. The buyback of shares was allowed only if the Articles of Association12 of the company permitted it to do so. The ordinance also required the company to pass a special resolution at a general meeting and obtain the shareholders' approval for the buyback. In addition, companies were not allowed to make a public or rights issue of equity shares within a period of 24 months from the day of completing the buyback, except by way of bonus issues and conversion of warrants, preference shares or debentures. The ordinance did not lead to increased buyback activity by multinational companies. In the financial year 1999-2000, only six MNCs came out with buyback offers, and in the year 2000-2001, only eight more companies offered to buyback shares. According to the analysts, the low level of buyback activity in 1999 and 2000 could be attributed to the fact that buyback regulations were very elaborate and discouraged companies from making use of buyback option (Refer Exhibit I for the buyback process and Exhibit II for methods of
buyback). The lack of interest in the buyback option could also be the result of SEBI's restrictive regulations. Some companies complained that the process of buyback was delayed because the law required them to obtain shareholder approval for offering a buyback. SEBI guidelines prevented companies from raising fresh equity to finance their projects. It also prohibited any subsequent buyback offer by the same company once it had made one for a period of two years. These complaints and the need to revive the stock markets after the September 11, 2001 terrorists' attacks in the US forced the government to make amendments to the buyback ordinance. The government made amendments to the buyback ordinance in October 2001, relaxing the buyback norms. The new amendments allowed the promoters of a multinational company to make an open offer to purchase up to 10% of its equity without making a public announcement. This purchase just required a mere approval from the board of directors. However, a public announcement and shareholder approval were necessary for any offer above 10%. The amendments also reduced the time limit for issuing fresh shares from 24 months to 6 months. These two changes were incorporated into the buyback ordinance, which was passed by the government in December 2001 (and subsequently became the Buyback Act). The amendments in the buyback ordinance coupled with depressed stock market conditions saw an increase in buyback activity. MNCs (through the open offer route) regarded the buyback option as an opportunity to raise their equity stake in their Indian ventures. In the financial year 2001-2002, twenty MNCs made buyback offers. Some of the wellknown MNCs which offered to buy back their shares were Philips India Limited (Philips), Cadbury India Limited (Cadbury), Britannia Industries Limited (Britannia), Carrier Aircon (Carrier) and Otis Elevators (Otis). All these companies made open offers for the nonpromoter shareholding in their Indian subsidiaries. To buy back shares, Cadbury paid Rs 9 billion, Philips Rs 2 billion, and Carrier, Otis and Reckitt Benkiser all paid over Rs 1 billion (Refer Table I for MNC buybacks). According to analysts, the increased buyback activity by MNCs was due to three reasons. They felt that the share prices of most MNCs were under priced and did not reflect the true value of the company. Moreover, the buyback of shares allowed MNCs to convert their Indian ventures into wholly owned subsidiaries (WOS).13 It also allowed them to delist the shares of these ventures from the stock markets and thus protect them from the volatility of the stock markets (caused by scams and other market manipulations).14
Table I MNC Buyback Offer Details % of Shares offered for Buyback
Opening Closing Date Date
Philips India Open Limited* Offer Philips India Open Limited@ Offer Cadbury Open India Limited Offer Carrier Aircon Otis Elevator* Otis Elevator@ Reckitt Benkiser Britannia Open Offer Open Offer Open Offer Open Offer Open Offer
13-Nov-00 12-Dec-00 Rs. 105 49.00% 21-Nov-01 ----------- Rs. 105 17.34% 13-Dec-01 Mar-02 2-Jul-01 31-Jul-01 Rs. 500 49.00% Rs. 100 49.00% Rs. 280 31.10%
18-Oct-02 16-Nov-02 Rs. 320 19.38% 14-May-02 13-Jun-02 Rs. 250 49.00% Sep-01 ---------Rs.750 49.00%
Source: Indiainfoline.com, domain-b.com * First open offer @- Second open offer. Analysts also felt that MNCs had used the buyback of shares as a method for distributing surplus cash15 to their shareholders. Buyback also acted as a tool for creating wealth for the shareholders. The buyback of shares improved a company's return on equity (ROE),16 and this improvement would ultimately be reflected in a higher price earning ratio.17 Buyback by the company usually indicated that the management felt that the stock was undervalued. It resulted in an increase in stock price, bringing it closer to the intrinsic value. For example, when Philips announced its first buyback offer at a maximum price of Rs.105 in October 2000, its shares were trading at around Rs 60. The buyback announcement resulted in an increase in the share price to Rs 90 even before the buyback offer opened on November 13, 2000. Hence, the buyback offer gave shareholders an exit option that paid them a premium over the pre-buyback share price. However, in spite of the benefits of buyback, a section of analysts and investors felt that it was being misused by MNCs.
Analysts felt that the buyback option may be misused by MNCs to increase their equity stakes in their Indian ventures, escape public scrutiny and accountability and prevent
themfrom the Indian regulatory environment. Moreover, the option to convert their Indian ventures into wholly owned subsidiaries and delist their shares from the stock markets provided MNCs with complete control over their Indian ventures, allowed them to repatriate profits and make more independent investment decisions. A section of investors felt that government regulations must have provided them with a choice. However, minority shareholders claimed that they had no option and were forced to sell their shares once MNCs bought back shares from the majority shareholders. For example, because Life Insurance Corporation (LIC) and the General Insurance Corporation (GIC), who together held a 21% stake in Philips, surrendered their shares when Philips made its first buyback offer, the minority shareholders were forced to surrender the remaining shares when Philips made a second offer in November 2001 (Refer Table II). Reportedly, investors feared losing an exit option in case the shares get delisted. Moreover, during the second offer, the trading volume of shares fell to less than (on an average) 500 shares per day since December 2001. Table II Share Holding Pattern in Philips India Limited Share Holding Pattern as on (%) Foreign Promoters Institutional Investors Private Bodies General Public 30/06/2002 31/03/2002 31/12/2001
92.34 0.07 0.14 7.4
91.47 0.07 0.18 8.22
82.86 0.85 1.49 14.67
Source: www.indiainfoline.com Similarly, when Cadbury made a buyback offer, public shareholding fell from 26.67% to just 7.32% within six months after the majority shareholders surrendered their shares (Refer Table III).
Moreover, in this case, investors felt that the premium offered by Cadbury Schweppes, the UK based parent company of Cadbury, was low. The offer was priced at Rs 500, which represented a premium of 24% on the average high and low prices over the past 26 weeks prior to the offer. However, Cadbury's stock had been trading at prices in excess of Rs 500 in 1999 and 2000 (Refer Table IV), with an average P/E multiple of 60 in 1999 and 54 in March 2000. Moreover, Cadbury's third quarter (October to December 2001) sales had increased by 11.2% compared to the same period in 2000, while its profits had increased
by 5.2%. Hence, investors felt that the price offered for the buyback had not taken into consideration the future potential profits of the company and was not attractive to shareholders who had been holding their shares for a longer term. As a result of depressed stock market conditions, investors (in most cases) received a low buyback price. The price at which the open offers were made by MNCs caused great concern to both investors and regulators (Refer Exhibit III for details of pricing parameters of open offers). Table III Share Holding Pattern in Cadbury India Limited Share Holding Pattern as on (%) Foreign Promoters Institutional Investors Private Bodies General Public 30/06/2002 31/03/2002 31/12/2001
90.25 0.10 2.25 7.32
51.00 0.22 33.18 15.46
51.00 20.36 1.71 26.67
Source: www.indiainfoline.com In many cases, minority shareholders had expressed their opposition to the use of discriminatory pricing by MNCs for buying back shares. For example, Otis Elevators bought back 23.9% of the equity stake from the Mahindra group at Rs.375 per share in October 1999, but made a buyback open offer for only Rs. 280 for the remaining 31% of the shares held by the Indian public in May 2001. Table IV Share Prices on First Open Offer by MNCs Price Price 1 Maximum 2 Company Premium year Offer Buyback year Name offered18 prior Price Date prior to (BD) to BD BD Price on Philips Cadbury Carrier Aircon Otis Elevator Reckitt 105 500 100 280 250 90.5 483 98 175 245 46% 5.90% 53% 41.40% 5% 110 589 88 315 211 148 566 218 306 Price on 1Jul02 103 493 99 287
Benkiser Source: www.myiris.com Analysts also felt that the buyback option was not beneficial for small investors. Allowing MNCs to delist their shares from the stock market would deprive Indian shareholders of good investment opportunities. For example, in few companies including Philips, Carrier, Reckitt, Cadbury and Wartsila, the promoter's stake had almost crossed 90% (Refer Table V). Though these companies had not delisted their shares from the stock markets, there was hardly any trading in these companies' stocks. Table V Shareholding Pattern as on 30/6/2002 (In %) Name Philips India Limited Cadbury Carrier Aircon# Otis Elevator Reckitt Benkiser* Wartsila Institutional Foreign General and Other Promoter Public Investors 92.34 90.25 91.16 80.62 82.84 88.13 0.26 2.43 9.21 1.23 6.37 7.4 7.32 8.84 10.18 15.93 5.49
Source: Indiainfoline.com # Carrier Aircon has also made its final offer to acquire the remaining 8.84% of its stock. The offer opened on September 9, 2002 and would close on March 7, 2003. * The foreign promoter Reckitt Benkiser had acquired 87.27% of Reckitt Benkiser India Limited shares by September 2002. It had already made an open offer for the remaining 12.73% in August 2002. Analysts argued that like China and Indonesia, India must revert back to a system that prevented multinationals from delisting their shares from the stock exchange by prescribing a minimum amount of floating stock. The buyback by MNCs not only affected the small shareholders, it also had an impact on the stock exchanges. The buyback of floating stock resulted in a decline in the trading volumes. For example, the Delhi Stock Exchange was badly affected as MNCs accounted for more than 90% of the volume traded and 85% of the listing fees earned by the exchange before the buyback act was introduced. Given the negative impact of the Buyback Act, market observers felt that the act had failed to revive the capital markets.
Buy or Not to Buyback?
The dilemma that faced small investors in India was whether the buyback option, along with the SEBI guidelines, actually protected their interests and offered them an exit option at a fair price or was it a tool that provided them with no options allowing large MNCs to gain complete control of their subsidiaries. Investors felt that the regulations framed by SEBI did not have provisions for preventing good stocks from delisting. Moreover, the buyback price, which was determined using the parameters specified in the SEBI Takeover Code, did not consider the future potential of the stock (Refer Exhibit III for details of pricing parameters of open offers). They felt that SEBI should have looked at various financial parameters such as future cash flows, value of brands and the value of fixed assets to determine a pricing formula for open offers which ensured that investors who had been holding the stock for several years received a fair price for their investment.
Questions for Discussion
1. What were the objectives of the buyback ordinance issued by the Government of India in 1998? Describe the salient features of the buyback ordinance. Why did MNCs want to buy back the shares of their Indian ventures? Explain. 2. The depressed stock markets in India are being utilized by several large MNCs to increase their stake in their Indian subsidiaries through the buyback of shares. Explain in detail the different methods of buyback available to an organization. 3. According to minority shareholders, MNCs had misused the buyback option. Explain the various grievances of minority shareholders regarding the buyback of shares. 4. Do you think stringent measures should be introduced to protect the interests of small investors? What should SEBI do to safeguard small investors' interests and resolve their grievances?
Exhibit I: The Buyback Process Exhibit II: Concept Note – Methods of Buyback Exhibit III: Pricing Parameters for an Open Offer to Buyback Shares
1] 'Multinationals Leave Indian Investors Stranded,' Raju Bist, Asia Times, June 5, 2002. The Investor Grievance Forum is a 2] Private Mumbai bodies refer to overseas based corporate bodies investor as well as private protection companies investing in body. shares.
3] Delisting is a process by which a company's shares are removed from the stock exchange. According to the listing agreement, if the general public shareholding falls to less than 10%, the company has the option to delist. 4] A hostile takeover involves the acquisition of a certain block of equity shares of a company giving the acquirer a greater stake in the company than the promoter. This enables the acquirer to exercise control over the affairs of the company 5] SEBI was established by an act of Parliament in 1992 to protect the interests of small investors and to promote the development 6] According to of SEBI's and Buy Back regulate of Securities the Regulation, securities 1998, Chapter market II, in of India. Buyback.
7] The buyback had to be based on the proportion of shares held by an investor in case the buyback was oversubscribed. 8] The process of securing the optimum price for a company's share. The issuing company decides the price of the security by asking investors how many shares and at what price they would be interested in paying.
9] Odd lot holders refer to investors holding an odd multiple of shares less than 100 or 10. Odd lots are also called broken lot/uneven lot. An uneven or broken lot might be caused by the issue of rights shares or conversion of debentures and warrants. 10] A spot transaction involves a purchase or sale of a security with an immediate delivery for cash.
11] An open offer refers to an offer made by a party (the foreign promoter) to acquire shares of a company (Indian subsidiary) at a particular price. It is done with the objective of increasing the promoters' stake in a company 12] The Articles of Association contain the rules and regulations for the management of the internal affairs of a company
13] A company in which 100% of the voting stock is owned by the holding company. In India, once the promoter holds more than 90% of the voting stock, he/she can delist the company from a stock exchange.
14] Manipulations include the artificial increase in the volume of shares traded through trading within the group companies or dumping of shares by Foreign Institutional Investors. Such manipulations made the share price volatile. 15] Financial theory states that if a company does not have any investment opportunities where the internal rate of return (IRR) of the investment is at least equal to the company's cost of capital, it is more prudent for the company to utilize the surplus 16] Return on cash equity is to the ratio buy between the back Net Profit and its Net own worth of the shares. company.
17] It is the ratio between the market price of the share and the earning per share. 18] Premium on the market price prevailing on the date of announcement of the buyback.
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