Conflicting views on the buyback of shares continue to baffle investors
Private equity and venture capital investors often favour preference shares as an investment instrument over equity shares. This is because preference shares have precedence with respect to the repayment of capital at the time of liquidation and are also entitled to a defined dividend in priority over other shareholders of a company.
To qualify as foreign direct investment (FDI) under India’s FDI policy, preference shares are required to be compulsorily and mandatorily convertible into equity shares. Under the FDI policy, if preference shares are not compulsorily convertible (i.e. they are optionally/partly/non-convertible preference shares), then such foreign investment would be treated as debt and would be subject to stringent guidelines on external commercial borrowing.
The buyback of shares is one of many common exit rights incorporated by investors in their agreements. However, investors often remain oblivious of the legal challenges involved in implementing a buyback by an investee company. This article seeks to identify the issues faced in the implementation of a buyback of compulsorily convertible preference shares (CCPS) by an unlisted company in India under company law and foreign exchange management law.
Company law requirements
There are two types of share capital – equity and preference. India’s Companies Act, 1956, permits companies to buy back preference shares from their shareholders.
Under section 77A of the act, a company is permitted to buy back shares from its shareholders subject to certain terms and conditions. For instance, a company can only use money from its free reserves, securities premium account or the proceeds of any shares or securities (other than preference shares) to buy back CCPS. The company’s articles of association should authorize the buyback and the CCPS should be fully paid up. In addition, the amount paid as the buyback price should not exceed 25% of the total paid-up share capital and free reserves of the company.
Once the buyback has been completed, a company cannot issue any more preference shares for at least six months (other than bonus shares or issues of shares in pursuance of existing obligations). Following the buyback, the debt owed by a company cannot be more than twice the capital and free reserves of the company. The term “debt” includes all the secured and unsecured debt of a company.
If the proposed buyback of CCPS involves consideration equal to or less than 10% of the total paid-up equity capital and free reserves, the buyback can be approved through a resolution passed by the company’s board of directors. However, a company would not be able to carry out another purchase of its shares until 365 days after a buyback approved only by its board unless it has the approval of its shareholders by way of a special resolution.
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Kunal Arora and Priyanka Dixit Sibal are lawyers at MNK Law Offices in New Delhi. MNK Law Offices is a full-service law firm. It advises a wide spectrum of clients on matters related to mergers and acquisitions, private equity, infrastructure, real estate, and corporate and commercial law. The firm also represents clients in a wide range of litigation and arbitration cases related to both civil and commercial matters. The firm can be reached at firstname.lastname@example.org.