Buyback Norms: Welcome amendments but more needs to be done

The Securities and Exchange Board of India (SEBI) has decided to implement, to begin with, some of the recommendations made by an expert group headed by Keki Mistry as detailed in a consultation paper circulated on November 16, 2022, for public comments. Phasing out of buyback through the stock market route was one of the more substantial changes accepted for implementation. Other changes accepted include increasing the minimum utilisation of funds earmarked for buyback through this route from the existing 50 percent to 75 percent and creating a separate window for such buybacks. The markets regulator has also decided to allow an upward revision of the buyback price under the tender route till just one day before the record date.

The laws governing the buyback of shares were liberalised in 1998. Until then, the buyback of shares to reduce the capital needed to go through a complex process of court approval. The share capital was seen as a protective cushion for creditors that could be diluted only in exceptional cases. However, it was realised that flexibility of capital restructuring through buyback could be beneficial - with appropriate safeguards in place, healthy companies could return excess monies to shareholders.

Buyback is comparable to dividend payout, as that too enables the return of excess funds to shareholders. But dividend payout involves giving monies even to those shareholders who would rather keep it with the company. Also, different shareholders face differing tax treatment of dividends. In comparison, a buyback gives shareholders an option to participate in the process and decide on the number of shares that they would like to offer.

Buyback has been permitted primarily through three routes – open market, tender offer (or reverse rights) and book-building. The open market route has been controversial due to alleged abuse. Announcing a high-priced buyback through the stock market was an easy way to manipulate the share price. The company may not even buy shares even if they were available at a lower price. Often aspiring arbitrageurs who buy shares hoping to sell to the company at a higher price get trapped.

Buyback through the stock market route also involves management claiming better wisdom than the market. Worse, they could use company funds to prop up the share price. The Expert Group has recommended that rightly this route be phased out by 2025. SEBI has decided that the phase out will happen in a gradual manner. However, if there is consensus that this route was undesirable, why not eliminate it immediately? Why let the abuse go on for another three years?

Anyway, SEBI will now require that at least 75 percent of the amount committed for market buybacks should be actually used, as compared to the current 50 percent. This is a fair move, as it will curb non-serious buyback announcements that are meant only to manipulate stock prices.

SEBI’s decision to allow revision of the buyback price until one working day prior to the record date would give more flexibility to companies to make the offer more attractive. But a larger point has been missed. Unlike open offers, buybacks do not involve competition between the company and shareholders. In an open offer, typically a third party (or even the promoters) seek to buy shares and may revise the bid price to make it attractive. But buyback is an internal affair, with the management, particularly the independent directors, deciding upfront a fair price. Permitting revision would create uncertainty, tempting shareholders to wait till the last day, and give management an opportunity to compete with, or even act in a manner adverse to the interest of public shareholders. If price revision is allowed, there should be additional safeguards in place including approval from independent directors, advice from merchant bankers and disclosure of the reasons.

Finally, let us consider some recommendations that were not implemented. One that stands out is the tax treatment of buybacks, but that change is not in the control of SEBI. Buybacks, as discussed earlier, can often be an alternative to dividend payout. Unfortunately, the tax treatment of the two has been different and varying. This is partly unavoidable since the two structurally are different. But the government has vacillated from one extreme to the other in their tax treatment.

Further, in an eagerness to close every conceivable loophole, the law has become complex. Worse, as the report itself demonstrates with facts and figures, promoters have abused buyback whereby a substantial portion of the tax was borne by public shareholders. One may say that public shareholders could have participated in the buyback and also benefitted. But this may not be wholly fair considering how scattered, varied and powerless they are individually.

I make two suggestions here. One is that independent directors be given more say to ensure fair treatment to all groups. The other suggestion, though easier said and done, requires a holistic overhaul of tax laws so that the tax treatment of buyback is more equitable to, if not equal to, dividends.

To conclude, it is again a sad state of affairs that laws have to be made more and more complex and convoluted to prevent dishonest management from giving a raw deal to public shareholders. The Sebi chairman is right in saying that companies and promoters were complying with the letter of law but not with the spirit of the law. But again, the answer to that is not more rules and bans. The answer is an increased level of transparency that helps shareholders identify and get rid of unscrupulous promoters.