This article has been written by Ishaan Saraswat and Esha Rathi, Final year law students at Jindal Global Law School.
Introduction
Section 68 of the Companies Act, 2013 (“Companies Act” or “Act”), provides companies with the power to buy back shares. As per Section 68(1) of the Act, a buyback of shares is when a company acquires its own shares out of its free reserves, securities premium account or the proceeds of issue of shares, except out of the proceeds of the same class of securities. In a buyback, the company makes an offer to purchase your fully paid-up share. Subsequently, the shares are extinguished, which leads to a reduction of capital.
Buybacks are governed by the Act, accompanied by Private Company and Unlisted Public Limited Company (Buy Back of Securities) Rules, 1999 for private and unlisted public companies, or Securities And Exchange Board of India (Buy-Back of Securities) Regulations, 2018 (“Buyback Regulations”) for public companies.
The Buyback Regulations permit companies to undertake buyback offers through three routes: a tender offer from the existing shareholders or other specified security holders on a proportionate basis, the open market through the book-building process or stock exchange, or from odd-lot holders.
By way of this article, the authors discuss Paytm’s buyback strategy and raise concerns regarding its potential misuse and impact on corporate governance. It is argued that the buyback may be a poor investment decision since the company’s stock has been underperforming and the buyback may be a strategy to increase earnings per share (EPS) and stem the route in shares. Additionally, it is suggested that using excess cash reserves to finance the buyback hurts the company’s reserves and survivability. Hence, Paytm’s buyback may be driven by improper purposes and argue that the Buyback Regulations need to be overhauled to address these concerns.
Paytm’s Buyback
Open market through the stock exchange route was adopted by Paytm for their buyback scheme worth Rs. 850 crores at a maximum price of Rs. 810 per share, to be completed within a maximum of 6 months, as announced on December 13, 2022, as per Paytm’s buyback filing (“Buyback Offer”). At the maximum buyback price and the maximum buyback size, the indicative maximum number of equity shares repurchased would be 10,493,827 equity shares.
The rationale for a company to undertake a buyback programme is when it has surplus cash flow, which is sitting idle, or if its shares are available at a price below intrinsic value, making it an appropriate time to retire capital. Paytm has relied on the former reason by stating that it has liquidity of Rs. 9,182 crores as per its last earnings report and that “the management believes that given the company’s prevailing liquidity/financial position, a buyback may be beneficial for our shareholders” as per their Buyback Offer.
A Need to Overhaul Buyback Regulations
The aforesaid buyback comes just a year after the company went public on November 18, 2021, whereby the initial public offering (“IPO”) of Paytm was worth Rs. 18,300 crores, with Rs. 8300 crores raised in fresh capital and Rs. 10,000 crores as an offer for sale.
However, since Paytm’s listing in November 2022, Paytm’s share prices have plunged as much as 75 percent, emerging as the world’s worst-performing large IPO in a decade as per a report. Further, the share price fell 7 percent further on announcement of the buyback. It is not speculative to suggest that buyback is a strategy play for Paytm, in order to stem the route in shares and increase the Earnings Per Share (EPS). However, if Paytm is buying up shares at a premium, while the shares are not worth as much – as the market indicates – then the company is making a poor investment decision. The buyback is essentially a purchase of an overvalued stock, which thereby destroys shareholder value.
Further, the Companies Act, Section 68(1) proviso prevents any company from using proceeds of an earlier issue of the same class of securities for a share buyback, given that such proceeds can only be used for its specific purpose. It appears from Paytm’s Buyback Offer that the buyback will be financed from the “excess cash” and that the company may be spending approximately Rs. 850 crores (Rs. 1,000 crores including the taxes) on this buyback. However, utilizing such cash reserves hurts the reserves of the company making its survivability weak.
With this background, topped off with the cash losses that the company reports annually, the rationale of the buyback moves away from the existence of strong cash flow generation to manage the stock price, as certain investors raise concerns.
On December 20, 2022, SEBI approved the phasing out of buybacks through stock exchanges, thereby leaning towards the more equitable route of a tender offer. As per Regulation 2(1)(za) of the Buyback Regulations, a tender offer involves the company buying back shares directly from the shareholders on a proportionate basis and at a fixed price, thereby enabling each shareholder’s participation, as opposed to the open market route enumerated in Regulation 16 of the aforesaid regulations, wherein certain investors are left incapable of matching the market price despite the added premium by the company, as is witnessed in the Paytm debacle. However, the Buyback Regulations are still incapable of probing into the issues highlighted above, and merely provides for certain tix boxes to check, and not to enable governance of the issues therein.
A case for improper purpose?
Paytm’s buyback does not create a level playing field for the shareholders. The IPO had priced its issue at Rs. 2,150 a piece. With the company offering a buyback at a price not exceeding Rs. 810, which includes a 50 percent premium over the closing price on the board meeting day, the pre-IPO shareholders as well as employees with stock options at a significant discount to market price, will benefit. It is reported that the promoter-director, Vijay Shekhar Sharma has been issued 21 million stock options at Rs. 9 each in the Financial Year 2022-23, following which, a proxy advisory firm has called upon SEBI to examine the said promoter-director’s eligibility in being issued ESOPs.
Further, the purpose of the public issue as per the IPO encompassed investing in new business initiatives, acquisitions and strategic partnerships, none of which have been done as per the September 2022 quarterly statement.
The Companies Act provides two routes for the shareholders in this regard to approach the court of law in light of corporate governance issues within a company. The first is taking a direct action, i.e., the statutory remedy of oppression & mismanagement under the act. However, a direct action requires a personal wrong against the shareholder, which may not be the case here.
The second route relays that shareholders also have the common law remedy of derivative suits when there is a corporate wrong, i.e., the company is the victim of the wrongdoing. As per Foss v. Harbottle, the management and shareholders are supreme in their own spheres, and when there is a wrong done against the company, the management, i.e., the directors shall have the locus to approach the court. This is the proper plaintiff rule, which as per Menier v. Hooper’s Telegraph Works, shall be departed from if the wrongdoers are the directors themselves, and the shareholders shall have the locus therein.
Section 166(1) of the Companies Act provides that directors must act within the scope of powers which have been conferred upon them. The derivative action here is the proper purpose test, under which directors cannot have a bias towards a few shareholders. In Sangramsinh v. Shantadevi, it was held that even if the directors are of the view that an action is in the best interests of the company, a predominant improper purpose would nullify the transaction. Nevertheless, if there is an incidental benefit, then there is no negative effect on the transaction.
Coming to Paytm, the share price of Paytm is low, and a buyback may boost this value, leading to gains for the promoter-shareholders. This may seem like an axiomatic result of the buyback; however, the Paytm scenario is peculiar when we look at the surrounding facts, which suggests a predominantly improper act.
ESOPs were issued in the Financial Year 2022-23 to the promoter in large quantities at a price where massive gains can be made. The bulk of compensation for internal management is in the form of stock options. Buyback may hence have an ulterior motive of mopping up excess stock and maximizing EPS, hence increasing the wealth of the stock option holders. Furthermore, the purpose of the public issue was to raise capital to make investments and provide for organic and inorganic growth. However, performing a buyback implies that the spare cash cannot effectively be invested. Hence, the investment opportunities for which capital was raised by public issue have disappeared within a year.
Hence, it does not seem that the buyback is in the interests of the company, but rather in the interests of the shareholder-directors. Drawing from Needle Industries v. Needle Industries Newey, if the directors are performing the action of buyback, maybe to increase their shareholding or profit, while the company is running in losses and is unable to invest its surplus properly, they will have failed in their fiduciary duty to the company. Hence, even if there is a bona fide belief that the action is in the best interests of the company, this seemingly improper motive behind the buyback may set aside the transaction.
Conclusion
Buybacks are known to be used for manipulating the EPS ratio, flushing the stock prices upwards, giving a short-term boost to profitability, etcetera. In this regard, SEBI needs to establish a level playing field. Concerns have been raised that the buyback may be a poor investment decision and may be driven by improper purposes since the company is essentially buying an overvalued stock, which thereby destroys shareholder value. Furthermore, using excess cash reserves to finance the buyback may hurt the company’s reserves and survivability. The Buyback Regulations in India are insufficient to address these concerns, and a case can be made for improper purpose. The regulator needs to be cognizant of such aforesaid issues circling buybacks. Further, to ensure that buybacks align with the long-term goals of the company, the investors also must hold the company accountable. Though acting on such corporate wrongs through filing a derivative action is constrained, it is the one available mechanism to the investors, especially if there is an improper motivation behind the curtains.