Corporate Law Newsletter – Buyback of Shares : November 2024

Introduction

A buyback, or share repurchase, refers to a corporate action whereby a company repurchases its own shares from existing shareholders. This strategic manoeuvre results in a reduction of the number of shares on a pro-rata basis amongst the existing shareholders inter-se. Companies resort to the option of buyback for various reasons, including rewarding shareholders, enhancing financial metrics such as earnings per share (“EPS”), return on equity and restraining potential hostile takeovers by reducing liquidity of shares. Additionally, buybacks can signal to the market that the company possesses strong fundamentals, potentially boosting stock prices and attracting new investors. The Companies Act, 2013 read with the Companies (Share Capital and Debentures) Rules, 2014 (“Act”) provides the legal framework governing, regulating and restricting buybacks. 

Governing Buybacks: The Companies Act, 2013

The Act stipulates certain conditions to be met for a buyback process to be permissible as stated below: 

1. The company can buyback its fully paid-up securities as authorized by the articles of association of the company. 
2. The buyback must be completed within a period of one (1) year from the passing of the special or board resolution, as the case may be.
3. The buyback should not exceed Twenty-Five (25) % of the total paid-up capital and free reserves of the company as per its latest audited financial statements (“Prescribed Limit”). 
4. The Act further mandates that when a company buys back its shares, it must transfer a sum equal to the nominal value of the shares bought back to a Capital Redemption Reserve Account, to ensure that the capital of the company remains intact, with such transfer being disclosed in the balance sheet. 

Contravention: Any contravention of the buyback provisions under the Act, or any SEBI regulation by listed companies, may attract a fine between INR 1,00,000 to INR 3,00,000 for the company, and imprisonment up to three (3) years or fine between INR 1,00,000 to INR 3,00,000 for any officer in default. 

Restrictions on Buyback Transactions: Section 70, Companies Act, 2013

Section 70 outlines the restrictions under which a buyback cannot occur. A company is prohibited from buying back its shares or securities under the following circumstances:

1. If such purchase is through any subsidiary companies (including own subsidiaries) or any investment company (or group thereof).
2. If it has defaulted on repayment of deposits or interest, redemption of debentures or preference shares, payment of dividends, or repayment of loans including interest to financial institutions or banks. This restriction shall cease to exist if default is remedied, three (3) years have elapsed since such remedy.
3. If it has not duly filed its annual returns or financial statements as required by the Act or failed to duly declare or disburse dividend as required by the Act.

Difference between Capital Reduction and Buyback of Shares 

Capital Reduction permanently decreases the company’s share capital and can be undertaken through either of the following ways:

1. Reducing the nominal value of shares; or
2. Cancelling any paid-up share capital which is lost or is unrepresented by available assets (i.e., against accumulated losses); or
3. Paying off any paid-up share capital which is in excess of the wants of the company.

The primary goal of capital reduction is often to optimize the company’s capital structure and improve financial flexibility. Since capital reduction reduces the nominal value of shares or cancels shares entirely, it directly decreases the issued share capital. 

To reduce capital, the company must pass a special resolution specifying the reduction details, amend the share capital clause in its Memorandum of Association, and seek confirmation from the National Company Law Tribunal (NCLT).

In contrast, a share buyback occurs when a company repurchases its shares from its existing shareholders or open market (applicable for listed companies) or shares issued to employees through employee stock option scheme or sweat equity. Buybacks can be executed at market price and are typically seen as a way to reduce liquidity in the market and return excess cash to shareholders. The company must adhere to the Prescribed Limit under the Act.  

A share buyback does not impact the nominal share capital as in case of capital reduction. Instead, it reduces the number of outstanding shares in the market, which may indirectly affect the share price or value per share. Only fully paid-up shares can be repurchased by a company. 

Buyback as Strategic Exit Option in M&A

Buyback offers a strategic exit option for investors in the realm of private equity investments, mergers and acquisitions looking to liquidate their holdings in the company. This mechanism enables investors to sell their shares to the company, providing a well-defined path to liquidate their investment. The buyback price is typically negotiated and is based on fair market value or such other pre-determined price agreed upon by both the parties. 

Buybacks as an exit option provide a plethora of advantages for investors such as:  

1. Investors are provided with immediate liquidity through buybacks, allowing them to realize the value of their investment without relying on general economic fluctuations or lengthy processes like IPOs. 
2. Provides room to negotiate specific terms of exit with the company, such as the timing and volume of the buyback, enabling investors to optimize their exit strategy. For example, if the markets do not seem ripe for a listing (commonly negotiated as the first exit mode by investors), they may opt for a buyback. 
3. In some instances, buybacks can be structured to offer a premium on the market price, giving investors a higher return on their investment. 
4. Eliminates issues around onboarding new (sometimes unknown) shareholders on the cap table occurring in case of third-party sale, etc.

However, specific considerations and challenges arise when buybacks serve as an exit option for investors:

1. Companies must adhere to a complex regulatory framework governing buyback including the Prescribed Limit of shares that can be repurchased. In the event that the investor holds shares exceeding the Prescribed Limit, buy back of shares may not provide complete exit to such investor.  
2. Buy-backs must be offered to all shareholders proportionately, not selectively which makes it difficult for the investor to exercise the buyback as an exit option.  
3. The success of a buyback as an exit strategy often hinges on the company’s financial health. Companies with robust cash reserves may be more inclined to execute buybacks. 
4. Furthermore, under the Insolvency and Bankruptcy Code, 2016 (IBC), if a startup fails, shareholders’ claims are not prioritized as financial creditors, making buybacks a less secure exit in insolvency. For example, Info Edge wrote off its investment in Bijnis due to its economic instability, underscoring the risks of buyback clauses.  

Other Commercial Aspects of Buybacks

Buybacks may have strategic and financial benefits in certain cases. From a financial perspective, buybacks will increase the EPS of a company, hence benefitting shareholders. Buybacks are also used for signalling to potential investors that the company’s financial strength and fundamentals remain robust. Buybacks may also increase the share price, provided that such exercise is compliant with relevant laws, lest it be deemed as a form of market manipulation. 

One of the critical regulatory issues around buybacks was that the buyback of shares is used to return cash to shareholders by circumventing the dividend route, and thus evading tax liability. However, the recent amendment to the Income Tax Act, 1961 vide the Finance Act, 2024 has clubbed buyback proceeds with dividend income, and thus negated this critique. Therefore, no tax incentives are available on buybacks undertaken by companies after September 30, 2024. 

In conclusion, beyond just regulatory compliance, the company will have to undertake a thorough and balance analysis of its fundamentals, as well as some introspection on the rationale for any proposed buyback, before proceeding with such action.