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Buy Back of Shares

Written by: Saurav Paul - Student of Symbiosis Law School, Pune
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One of the first multinationals (MNCs) to offer buy back option was Royal Philips Electronics of Netherlands (Philips), the Dutch parent of Philips India Limited in the year 2000. The open offer was made at Rs.105, a premium of 46% over the then prevailing stock market price. Cadbury India, Otis Elevators, Carrier Aircon etc. soon followed suit. Fund managers which held these companies' stocks felt that allowing buyback of shares was one of most favorable developments in the Indian stock markets.

There are several reasons for which a company may decide to buy back shares issued by it.
The top three reasons are:
1)The company has surplus funds but does not have suitable projects to invest the funds in. Companies aim to maximize profits. For this they continuously seek to improve current projects, start new projects, expand into newer markets, acquire other companies etc. However there may be a situation wherein the company has lot of surplus money but it is unable to identify suitable avenues to invest that money. In such a situation it may consider using the surplus funds to buy back its shares from existing shareholders.
2) The company may seek to increase the market price of its shares. Buying back shares would reduce the number of shares that are available in the market for trading. This decrease in supply of shares may lead to an increase in the share price.
3) Buy back of shares is a defense to a hostile takeover. The buy back would reduce the shares available in the open markets thereby making it difficult for a potential acquirer to buy the shares required to takeover the company.

It is not open to a company to purchase its own shares, for s 77 of the Companies Act declares that no company limited by shares or guarantee and having a share capital shall have power to buy its own shares, unless the consequent reduction of capital is effected and sanctioned by the court’s consent, nor may a company do so indirectly by getting another person to buy the shares on its behalf. Buying its own shares by a company involves a permanent reduction of capital without the sanction of the court and which is illegitimate and in violation of law. The object of the section is to prevent a person from acquiring control of a company and paying for its shares out of the accumulated assets of the company itself. Exceptions to this section are lending of money by a banking company in the ordinary course of business, the provisions of money for the purchase of fully paid up shares in the company by trustees for and on behalf of the companies’ employees, and lending money by a company to its employees to enable them to buy fully paid shares in the company and to hold them by way of beneficial ownership.

Traditionally subject only to a few exceptions specified above, companies were not permitted to purchase their own shares. Section 77A brought in by the Companies Amendment Act, 1999, has caused this structural change in the theme and philosophy of company law that, subject to the restrictions envisaged in the section, a company may buy back its own shares. Thus now it falls under the exceptions where no confirmation by the court is necessary. Buy back is governed by SEBI guidelines 1998.

S 77A of the Companies Act authorizes a company to buy back its shares out of its free reserves, the securities premium account or the proceeds of any shares or other specified securities. However the company is not permitted to make a buy back any a security out of the proceeds of an earlier issue of the same type of securities.

Sub section 2 of 77A prescribes certain 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 should be passed. The amount involved in buy back should be less than 25% of the company’s total paid up capital and free resources. After the buy back, the ratio between the debts owed by the company should not be more than twice the capital and free resources of the company. The shares to be bought back should be fully paid. The buy back should be in accordance with SEBI regulations in case of listed securities. An amendment introduced in 2001 provides an exception to the operation of sub sec 2 in case the buy back is 10% or less of capital and free reserves then shareholders’ resolution is not necessary.

The explanatory statement to the notice for special resolution for buy back must contain the following:
1) the date of the Board meeting at which the proposal for buy back was approved by the Board of Directors of the company,
2) the necessity for the buy back,
3) the maximum amount required under the buy back and the sources of funds from which the buy back would be financed,
4) the basis of arriving at the buy back price,
5) the number of securities that the company proposes to buy back,
6) the aggregate shareholdings of the promoters and persons who are in control of the company as on the date of the notice convening General Meeting or the Meeting of the Board of Directors. Control includes the right to appoint majority of the directors or to control the management or policy decisions.
7) Aggregate number of shares purchased or sold by persons during a period of six months preceding the date of the Board Meeting at which the buy back was approved till the date of notice convening the general meeting,
8) the maximum and minimum price at which purchases and sales referred to above were made along with the relevant dates,
9) intention of the promoters and persons in control of the company to tender shares for buy back indicating the number of shares, details of acquisition with date and price,
10) a confirmation that there are no defaults subsisting in repayment of deposits, redemption of debentures or preference shares or repayment of term loans to any financial institution or banks,
11) a confirmation that the Board of Directors has made a full enquiry into the affairs and prospects of the company and that they have formed the opinion that the buy back will not adversely affect the company’s solvency and financial stability and lastly
12) a report addressed to the Board of Directors by the company’s auditors stating that they have inquired into the company’s state of affairs and the amount of the permissible capital payment for the securities in question is in their view properly determined and the Board have formed the opinion referred to above on reasonable grounds and that the company will not, having regard to its state of affairs, be rendered insolvent within a period of one year from that date.

A copy of the resolution is required to be filed within seven days with SEBI and the stock exchanges where the shares of the company are listed. SEBI Guidelines, 1998 prescribes three methods of buy back.

A company may buy back its shares from its existing shareholders on a proportionate basis from open market through stock exchange, through book building process or from 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.

The company shall extinguish and physically destroy the security certificates bought back in the presence of a Registrar to issue or the Merchant Banker and the statutory Auditor within 15 days of the date of acceptance of the shares. Provided that the company shall ensure that all the securities bought back are extinguished within seven days of the last date of completion of buy back.

Buyback of shares helps promoters hike their holdings at company’s expenses. It leads to improvement in earnings per share (EPS) as the equity is reduced to the extent of shares bought back. Buyback also helps keep investor morale high as it shows that the concerned company is financially sound and has enough cash to buy its own shares. While Corporates are trying to benefit from the current weak market, investors may not have gained much out of buyback offers. Even though the offers from the companies are at a premium to the prevailing market prices, the fact remains that the respective shares do not witness any major uptrend during the buyback period, thus benefiting the companies and not investors.

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 delisting 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 thus affecting their liquidity.

The buyback of shares allowed MNCs to convert their Indian ventures into wholly owned subsidiaries (WOS). 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).The buyback option may be misused by MNCs to increase their equity stakes in their Indian ventures, escape public scrutiny and accountability and prevent them from 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, allow them to repatriate profits and make more independent investment decisions. Minority shareholders claim that they have no option and are forced to sell their shares once MNCs buy back shares from the majority shareholders.

The dilemma that faces small investors in India is whether the buyback option, along with the SEBI guidelines, actually protects their interests and offers them an exit option at a fair price or is it a tool that provides them with no options allowing large MNCs to gain complete control of their subsidiaries. The regulations framed by SEBI do not have provisions for preventing good stocks from delisting. Moreover, the buyback price, which is determined using the parameters specified in the SEBI Takeover Code, does not consider the future potential of the stock. SEBI should look 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 ensure that investors who have been holding the stock for several years receive a fair price for their investment.

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