The other sides of the share buy-back option

The decision of the government to amend the Company Act 1994 allowing the companies to buy-back their own shares seems to have been well received by the investor community of the country. The prices of the shares in Dhaka and Chittagong Stock exchanges moved positively with the declaration by the finance minister. Under the share buy-back option, a company is allowed to purchase back its own shares that would ultimately result in permanent or temporary reduction of capital. Companies might be interested to opt for this action for various reasons. A company which foresees limited or no growth opportunities, may find it worthwhile to pay out its free cash to its shareholders in the form of buying back the shares. There are many companies which were once high-growth, high-performing companies but gradually reached their maturity or lost their growth potential for technological innovation or other reasons. In such situations, buy-back options could give some benefits to the existing shareholders. Similarly, if a company finds that its shares are undervalued for whatever reasons it might be, it may apply its right to buy back the shares and thereby raise the market value of its traded securities. Companies may also exercise this option to increase its controlling shares. Sometimes the buy-back option is applied as defense to prevent potential acquisition by others, increasing the EPS, giving shareholders the benefit of capital gain rather than the dividend. The ultimate consequence of any buy-back action is, however, to increase the intrinsic value of shares and thereby benefiting the shareholders. This outwardly benign power of the company is approved in the company law statutes of many countries of the world including India, Pakistan, and the UK. Bangladesh Company Act currently in force does not allow companies to buy its own share. However, there is a provision in the act that permits companies to reduce its capital. Any company willing to reduce its paid-up capital may do so following a lengthy procedure including court's approval in this respect. The issue of authorizing companies to buy-back its own shares was in discussion for quite a number of years but could not adequately draw attention of our policymakers. It would therefore be interesting to look into the rationale behind introducing the buy-back system in this country at this time. What are we going to achieve through this law? If we look at the background, we see that the issue came at a point when the capital market of the country experienced a temporary collapse after an irrational rise of the index to 9000 points. Experts, analysts, logical investors- every one was holding the view that such ballooning of the prices of the shares were unjustified in relation to the fundamentals of the companies being traded in the market. Even the Securities and Exchange Commission periodically cautioned the investors and advised to act rationally before buying shares. In such a situation, the collapse of the market was inevitable and the correction of prices was more than a necessity. Even at this current index level of around 6000 points, how many of the companies can claim that the prices of their shares are under- valued in relation to their performance? Rather, the general view is that most of the companies with their weak fundamentals are still overvalued. If this is the situation then why are we going to allow the companies to buy-back their shares? It would be illogical to think that a non-performing company, with weak fundamentals being traded at an overvalued price, will at all be interested to buy back its shares. The other point to remember is that there is dearth of quality shares in our market. Experts over the years were talking of increasing the supply of quality shares to tackle irrational rise in the prices. Now, if taking the opportunity of the buy-back provision, companies with good fundamentals opt for reduction of their capital, will it be beneficial for long-term sustainability of our capital market? Thomas Gresham, an economist in the 15th century, formulated the economic principle called the Gresham's Law which stated that "bad money drives good money out of circulation". In simple terms, the principle states that "when government compulsorily overvalues one money and undervalues another, the undervalued money will leave the country or disappear into hoarding, while the overvalued money will flood into circulation". Our regulators while devising the buy-back policies should ensure that we are not driving our good shares from the market? One point of concern that deferred implementation of the buy-back provision is the risk of market manipulation by dishonest companies. This is particularly important for imperfect capital markets like ours. It is sometimes feared that through this option the unscrupulous controlling shareholders may artificially downgrade the market value of the securities and buy them at the expenses of the shareholders in general. This is not necessarily true that such under-statement of value shall have to be done through illegal means. Companies through their action within their legal framework may make the shares less attractive to the shareholders, in general. For example, a company that wishing to buy-back its own shares may avoid paying dividends or paying low rates of dividends to make the shares unattractive. Since the companies are barred for a short period usually one year from fresh issue of capital, they may subsequently issue further shares at a suitable time. In a capital re-structuring situation, a company may opt for buy-back of its one kind of securities and finance such buy-back through issuance of other securities-e.g bond may be issued to finance redemption of equity securities. While the companies might have valid reasons to do so and law should not bar such actions, it is equally important that buy-back laws should guard against any unholy purpose of temporary gains by the companies through such swapping process. In most of the laws, shares purchased back are usually retired. This means that the paid-up capital of the company gets reduced. Any reduction of capital poses extra risks for the lenders and creditors. The amended company law should address this issue of how the creditors and lenders' interest shall be protected in such cases. Another point to consider is the issue of tax. Companies are required to pay tax at the rate of 10 per cent on the dividend paid. However, if the company chooses to pay away the surplus cash to the shareholders in the form of share buy-back, shall it be taxable? Generally, such gains of the shareholders remain out of the tax net. Therefore, it is important to look into that companies do not resort to the mechanism to avoid taxation. This is particularly important in case of companies that have foreign shareholdings. The company may refrain from paying dividend or paying low rates of dividend and thus build up its reserve and surplus. It may then go for purchase of its own shares. The foreign investors in such cases will be able to repatriate their profit in the form of selling their holdings without paying any dividend tax which is currently 25 per cent. If the companies are not barred from repeated fresh issue they can again raise their required fund for investment after the statutory break period which is planned to be one year after buy-back in the proposed new law. It is, therefore, important that before amending the existing law our regulators are clear about the purpose which is going to be achieved through the changes and design the law with due considerations of the factors so that the best interest of the market vis-a- vis its stakeholders are adequately protected. The writer is a Fellow of the Institute of Cost and Management Accountants of Bangladesh and can be reached at e-mail: choudhuryjamal@yahoo.com