Monday, December 15, 2008

Shares and Stocks: India and Delaware

India has largely followed the scheme of the erstwhile British company law in enacting the Companies Act, 1956. This is true even in the case of share capital structures that companies can have, such as only two types of shares, preference shares and equity shares for public limited companies, and also restrictions on companies dealing with their shares, such as rules against trading by a company in its own shares and prohibitions on “financial assistance” (section 77 of the Companies Act). Although the Companies Act has undergone amendments over the years, India has retained most of the original restrictions regarding share capital of companies, with some relaxations made from time to time (e.g. permitting equity shares with differential voting rights and buyback of shares, albeit with several restrictions). The U.S. (Delaware in particular), on the other hand adopts a liberal regime when it comes to share capital structures and permitting a company to deal with its own shares.

In this context, I recently came across an interesting paper by P.M. Vasudev titled Capital Stock, Its Shares and Their Holders: A Comparison of India and Delaware that compares the law governing share capital in India and Delaware. The abstract from SSRN is as follows:

The paper explores the origin of “shareholder supremacy” in Anglo-American corporate law and the present legal position of corporate capital stock, its shares and their holders. The study is comparative, and the statutes of India and Delaware are selected for comparison. The paper argues that Indian company law, which is based on English law, adopts the “business model” of corporations that gives at least as much importance to the business of companies as it does to their finances. But American corporate law, as it has evolved over the last two hundred years and exemplified by the Delaware statute, creates a “financial model” in which corporations are treated mostly as issuers of securities, and the statute treats the securities as commodities in which corporations deal. The Delaware statute has a bias in favour of the stock market and adopts the policy of encouraging trade in the securities.

The paper traces the process of development of corporate law in the two jurisdictions, and attempts to explain the divergence in their philosophies in the context of the respective developmental processes. The implications of the two philosophies for corporate behavior and governance are also examined. The comparison also illustrates how Indian company law is converging towards the American financial model, since the government of India adopted the policy of economic liberalization and globalization in the 1990s.
While it is true that Indian law is now moving in the direction of a liberalised share capital regime, particularly since the late 1990s, several restrictions continue to operate, and the pace of reform is considerably slow. Public companies can still carry only two types of shares, preference and equity (with the exception of equity shares with differential voting rights, which are also subject to several conditions). All shares need to carry “par” value; companies need to have an authorised share capital and a minimum share capital (Rs. 0.1 million for private companies and Rs. 0.5 million for public companies) - while these concept are being considered restrictive and hence progressively abolished in several jurisdictions.

Further, under Indian company law, there are stringent conditions under which a company can deal in its own shares. Previously, a company was unable to buyback its shares. However, in 1999, the Companies Act was amended to allow companies to buyback their shares, subject to certain conditions. Such conditions include the following: (A) a company can expend no more than 25% of its net worth to buy back its shares; (B) the total number of shares bought back each year cannot exceed 25% of the total paid-up share capital; (C) the debt-to-equity ratio of the company following the buyback should be no more than 2:1; and (iv) the directors are required to provide a solvency statement on oath (that the company would not be rendered insolvent within a period of one year).

There is another possible avenue for companies to repurchase its shares without complying with these restrictions, but that requires the company to obtain the approval of the High Court (section 100 of the Companies Act).

Indian company law also carries prohibitions against “financial assistance” by companies in relation to acquisitions of its own shares. The term “financial assistance” has been given wide interpretation, and this imposes significant hurdles on the ability of acquirers to borrow money for their acquisitions on the strength of the target company’s own assets, through the classic “leveraged buyout” (LBO) structure.

Most countries in the Commonwealth are moving towards a “solvency” approach to capital maintenance, whereby companies are free to deal with, or finance the acquisition of, their own shares as they please, if the companies continue to remain solvent after that (thereby protecting the interests of the creditors). So long as solvency is assured, the law does not intervene. However, the progress of Indian law towards such a solvency approach is considerably slow, with the regulations still imposing stringent conditions.

My purpose here is not to advocate for an unrestricted regime in India that may allow companies to freely deal with their capital, but to highlight the need for a comprehensive review of the share capital provisions of the Indian company law in the context of modern business needs. That opportunity is currently available in the form of the Companies Bill, 2008; but, sadly, the Bill does not make much headway on these issues.

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