Buyback Gives Creditors Almost Nothing

A virtual movement has been orchestrated over the last two years of the stock market bear phase to permit companies to buy back their own shares so as to prop up values.

The British Companies Act of 1985 allows it but the basic issue for us is: should buyback be permitted in a country where the existing institutional machinery for safeguarding minority shareholder interests is inadequate.

Quoting a Bank of England document, the expert group that defined the new companies bill has justified buyback on five grounds: to return surplus cash to shareholders, increase the underlying share value, support share prices during periods of temporary weakness, achieve and maintain a target capital structure and prevent or hostile takeover bid.

 

Assuming for a moment that the reasons for buyback are justified, the report does not say why is it necessary to reissue such shares, except for making a casual reference to treasury operations.

It seems that, in the opinion of the group, dealing in ones own shares, armed with insider knowledge, is the only way to efficient treasury operations!

The draft bill provides that companies will be permitted to buy back and reissue their own shares under certain conditions, subject to no restrictions on finances for funding such purchases.

Buyback will be permitted provided it is approved by a special AGM resolution and full disclosures made citing the reasons, class, amount to be invested and time limit for completion of the buyback.

A maximum limit of 15 months has been set for the completion of the buyback and no reissue can take place before 24 months of the date of the last buyback.

The draft bill also provides that shares bought back shall have no voting or dividend rights and at least two directors, one of whom will be the managing director, will give a solvency certificate, which will be valid for 12 months.

Total buyback?: Though the present section is drafted on the lines of the British Companies Act, the draftsmen have not understood the implications of that Act or have been so negligent as not to bother about its implications. Section 160(3) of the British act provides that all the shares cannot be bought back. There is no such provision under the draft bill. Therefore, what would be the position, if any company buys back all its shares?

How would the AGM be held; who would vote during it and what purpose would it serve? This is not a hypothetical argument because the power of buyback is being made available even to private limited companies.

Importantly, the British act provides that when shares are purchased out of free reserves or from the share premium accounts, an equivalent amount must be transferred from those to a capital redemption reserve. This is analogous to the redemption of preference shares.

This protection for creditors is totally dispensed with in the present draft.

Instead, a solvency certificate is required to be submitted to the central government to the effect that the board is satisfied that the company is capable of meeting its liabilities and will not be rendered insolvent within a year from the date of the declaration. It has to be adopted by the board and signed by at least two directors, one of whom has to be the managing director.

The solvency certificate cannot be a substitute for the capital redemption reserve, which provides real and not paper protection.

Though the directors are supposed to submit the declaration of solvency backed by an affidavit, if this affidavit turns out to be false, the penalty is limited to the imposition of a fine and punishment, without personal liability.

So, as far as the creditors are concerned, they have to fend for themselves. The buyback can be completed by the company in terms of provison to sub-section (1a) within 15 months from the date of passing the resolution.

So, the board of directors can give a certificate which is valid for 12 months from the date of declaration and purchase the shares in the remaining three months!

Solvency certificate: The certificate is supposed to certify that the company is capable of meeting its liability and will not be rendered insolvent within 12 months.

A company cannot be rendered insolvent in less than two to three years, whatever be its position, and definitely not within 12 months.

Significantly, this section does not talk of an act of insolvency, instead it talks of being rendered insolvent. The British act provides for a solvency certificate but in an altogether different circumstance for the financial assistance given by the company to purchase its own shares, while it provides for capital redemption reserve, when the company buys its own shares.

The British act, while providing for the solvency certificate, states that the assets should be taken at their book value and all the contingent liabilities should be considered.

No such condition is imposed in the draft bill. So a large leeway is left for the directors, in the unlikely event of being caught, to argue about the valuation of the assets and liabilities.

The draft bill does not say whether partly-paid shares can also be acquired. One presumes that in the absence of prohibition, even partly paid shares can be acquired.

What would happen in the event of the company going into liquidation while holding partly paid shares?

As far as redeemable preference shares are concerned, a specific provision has been made that partly paid shares cannot be redeemed.

Another condition is that after completion of the buyback, the company shall have a debt equity ratio not exceeding 2:1, or such higher equity ratio as may be prescribed.

The latter part has been left vague to accommodate various companies.

For instance, a fertiliser company will have a debt equity ratio of 13:1, power company 4:1, while an NBFC will have a debt equity ratio of 10:1.

What ratio is the government planning to prescribe in the absence of a capital redemption reserve and what sort of protection will it provide to creditors?

Frankly, what purpose does this provision serve?

The actual implications can be understood by an example. Before buyback, the directors can give a solvency certificate on the basis of the asset-liability position outlined in table I and the company can proceed with the buyback.

The assets-liability position after buyback is outlined in table II. Then after one year, the company distributes its entire reserves as dividend. The situation after this is depicted in table III.

Please note that as per the US regulations, own shares cannot be shown as assets. They have to be necessarily reduced from the share capital.

Now, what is the plight of creditors? The solvency certificate has expired and the reserves have been distributed. There is nothing to fall back upon. The companys main assets are its own shares.

These also will be of diminished value because the reserves have evaporated. Instead of having any other assets as security, the creditors would be having shares of the same company as security.

Though the example is hypothetical, the same results can be achieved with some variations, practically in each and every case.

Buyback has to be effected either from out of its free reserves, securities premium account or the proceeds of the prior issue made specifically for the purpose of buyback. Here also the word issue is kept vague.

It is not followed either by shares or debentures or any securities. So a company can issue debentures to buy back equity shares.

Suppose the debentures are redeemable after five years whereas a solvency certificate is issued for only a year?

Share cancellation: Under the British act, whenever a company purchases its own shares, those have to be cancelled automatically. It amounts to a sort of reduction of share capital. The British law does not give the right to reissue despite developed capital markets, a vigilant financial press, strict supervision and quicker justice.

However, the present draft bill gives such a right without considering the plight of ordinary investors when the companies themselves start operating in the market.

As per the bill, the reissue cannot take place for 24 months. If the company keeps on buying shares at different intervals, it will always have some shares to sell in the market and some shares to buy from the market. In other words, the company will be a jobber for its own shares in the market. (Concluded)