The debate on the desirability of allowing companies to purchase their own shares (buy-back) has raged intermittently through decades and has been the subject of many deliberations all over the world. In India, under Section 77 of the Companies Act, 1956, no company had the power to buy its own shares unless it was by way of reduction of share capital. The law also prohibited a public company from extending any financial assistance for the purchase of its own shares. The basic reason for such a prohibition was the feeling that allowing companies to buy-back their shares could give rise to companies trafficking in their own shares leading to undesirable practices in the stock market, like insider trading or other such unhealthy influences on stock prices. This general prohibition has been diluted by statute. The Companies (Amendment) Act, 1999 (Act 21 of 1999), permits a company whether public or private, after following the prescribed procedure to buy-back its own securities with suitable safeguards specified in Sections 77-A, 77-AA and 77-B.
Doctrine of Maintenance of Capital
English Company law recognizes the proposition that there is a price to be paid for limited liability in the form of restrictions on the use of the companys capital. Both David Gower and Paul L. Davies believe that the capital maintenance doctrine was borne out of a concern for the position of creditors in the wake of the development of the concept of limited liability. Creditors were, in effect, prevented from having recourse to the shareholders in the event that the company could not pay its own debts. As a result, creditors were forced to rely on the assets the capital of the company for repayment. Hence, it was necessary to ensure that a company operated with an appropriate level of assets, which consequently increased the chances that the claims of the creditors would be met. One of the leading English Cases on the point is that of Trevor v. Whitworth in which Lord Macnaghten stated that a company had no power under the Companies Acts to purchase its own shares, even so if authorized by its articles of association. Such purchases were held to be ultra vires and invalid by the court which opined that any such repurchase transaction was against the fundamental principle of company law that share capital should always be available for the purpose of meeting companys obligations as far as its creditors were concerned. Acquisition of its own shares by a company implies, in effect, reduction of its capital. Essentially the principle was that protection of the interest of the creditors of the company requires strict conformity with the statutory procedure prescribed for reduction in capital and any contravention will violate the doctrine of maintenance of capital. Then, it is to be noted that instances of a company providing assistance for buying its own shares have also been treated in the same generic group of a buy-back, as the effect of the transaction is almost the same as company re-purchasing its own shares. This rule is incorporated in Section 77 of the Companies Act, 1956. It is submitted that the desirability of allowing a company to purchase its own shares essentially rests on the acceptability of the Capital Maintenance doctrine itself in this contemporary situation.
Section 77 of the Companies Act, 1956
According to Section 13(4) of the Companies Act, a company needs to have a specified amount of share capital. Section 76(2) then stipulates that no company can allot shares at a discount in consideration for subscribing or procuring subscribers. Additionally, Section 205 which says that dividends are to be paid only out of profits. The above mentioned provisions are indicative of the principle stated in Section 77 about the bar on any other form of distribution of capital to shareholders. Further, it must be noted that under Section 100 there is a specific and formal procedure provided for the reduction of capital which is subject to certain safeguards and to confirmation by a tribunal. Before the introduction of Section 77-A, the only manner in which a company could have bought back its shares was by following the procedure set out under Sections 100-104 and Section 391 of the Companies Act which required the calling of separate meeting for each class of shareholders and creditors as well as (if required by the court) the drawing up of a list of creditors of the company and obtaining their consent to the scheme for reduction. It is submitted that Section 77-A was introduced to provide an alternative method by which a company may buy-back up to 25% of its total paid up equity capital in any financial year subject to compliance with sub-sections (2), (3) and (4). Section 77 essentially states that no company limited by shares, and no company limited by guarantee and having a share capital, shall have power to buy its own shares, unless the consequent reduction of capital is effected and sanctioned in pursuance of sections 100 to 104 or of section 402. Section 77(2) then furthers the objective of Section 77 (1) by providing that a company cannot give financial assistance for the purchase of its shares. This is to ensure, at least, that those who buy shares in companies do so from their own resources and not from those of the company.
The proviso to Section 77(2) carves out certain exceptions to this general rule. These include employee share schemes and also the protection of banks which have to make loans in the ordinary course of their business. Sub-section (5) then exempts a company which had to redeem any shares issued under Section 80. Furthermore, a purchase under a scheme of arrangement or amalgamation under Sections 391-394 (provided that the provisions of Section 100-104 have been complied with) and a purchase under an order of Company Law Board to purchase shares of minority shareholders under Section 402 (b) fall within the exceptions to the rule. It is submitted that Section 77(1) prohibits the purchase of own shares and is applicable to all companies- public and private. But Section 77(2) only prohibits public and private companies which are their subsidiaries from giving financial assistance to persons purchasing their shares. Section 77 is now subject to the provisions of sections 77A, 77AA and 77B which allow companies to buy back their own securities subject to certain specified safeguards and conditions to ensure that such a power is not abused.
Reduction of Capital Section 77-A
The Companies Act, 1956 was amended to allow companies to buy-back their own shares, and thus primarily to give a boost to the Indian capital market. Though many may disagree, there are many arguments in support of a buy-back power. Firstly, when a company buys back its shares it is possible that surplus cash is being returned to its shareholders that the company is unable to invest in projects that will generate a return greater than its cost of capital. Secondly, a company may be able to improve its share price as the number of shares available for trading in the markets will get reduced as a result of buy-back. Thirdly, a buy-back can be a very effective tool for blocking hostile takeover bids.
This power is also capable of being abused as it serves as a tool for the management to interfere with the ownership of the company. Section 77-A begins with a non-obstante clause and allows companies to repurchase their shares, notwithstanding any other provisions contained in the Act. The Section then provides for an elaborate framework to ensure that a companys right to buy-back its own shares is not abused. There is a clear demarcation of the fund from which a buy-back van be financed. Then, a buy-back exercise can be carried out only up to an amount up to 25% of the paid up capital of the company and the debt to free reserves ratio should not go beyond 2:1 after such an exercise. The shares to be bought back should be fully paid. There should be authorization in the articles of the company, a declaration of solvency and finally the whole process has to be authorized by a special resolution of a company at its general meetings so as to ensure shareholder protection. The buy-back should also be in accordance with SEBI guidelines which include daily advertisements, disclosure of purchases daily, declaration by promoters of the upfront pre and post buy-back holding in order to prevent manipulation, etc. Furthermore, Section 77-AA says that when a purchase is made out of free reserves, then a sum equal to the nominal value of the share purchased has to be transferred to the capital redemption reserve account. Section 77-B then prohibits a buy-back through any subsidiary company or investment companies. Also, a company which is in default of payment of deposits, redemption of debentures or preference shares or repayment of a term loan to any financial institution is prohibited from undertaking a buy-back exercise.
The need for a repurchase power came to be felt as a result of having lost sight of the essential terms of the bargain between shareholders and creditors, which allow for limited liability. Also, this capital can be frittered away in the course of trading and the same is evidence of the ineffectuality of the capital maintenance doctrine. The limited liability bargain requires that at least an attempt be made to do whatever can be done to protect the security of creditors, regardless of the chances of success/failure of those attempts. One may argue that buy-backs are inherently subversive of creditors interests. On the other hand, there is also an argument to the effect that with increased integration of global financial markets, a share buy-back power will facilitate increased capital mobility as individual shareholders will have the option to make personal judgments as to where to invest the capital which is returned. Furthermore, the ability to repurchase shares adds to the flexibility of the company to exercise greater control over its equity and its continued prohibition may serve to discourage portfolio investments. Lastly, it is submitted that though any conclusion in support of a share buy-back power will necessarily be diminished by the jurisprudential establishment and standing of the doctrine of capital maintenance, however, there are no two opinions about the fact that a repurchase offers considerable benefits to shareholders in terms of a viable exit option and increased earnings per share. Provided all the safeguards mention in Section 77 and those mentioned in the SEBI guidelines are followed, the entire buy-back process is an informed one and voluntary for the shareholders and offers considerable benefits to them. It would have been against the long term interests of corporate sector growth to continue with the prohibition on a repurchase power. For capital markets to be efficient in putting money to best use, companies need flexibility not merely in raising capital but also in returning the same. One should allow free market forces to operate and accordingly support a buy-back power for companies.