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MC Govardhana Rangan
The author is a post-graduate in Economics and has been a financial markets journalist for more than 25 years.
For more than three decades, financial engineering probably played a bigger role in creating wealth than economic activity on the ground. Some financial innovations helped improve economic activity, and some broke the financial systems they were supposed to strengthen. One tool of financial engineering is the share buyback by companies. It lets CEOs decide whether shares of their companies are traded below what they think they should be trading at, and push them up by buying it from the market with shareholder money.
It is said to be a way to return cash to shareholders when companies do not have any meaningful investment opportunities for future growth. Historically, excess cash or apart of profits was paid as dividends to equity investors. But share buybacks are beneficial to company executives because share prices rise without any improvement in corporate performance as the number of shares fall, and tax outgo is less. Sebi is now revisiting the rules governing share buybacks. A committee headed by HDFC CEO Keki Mistry has submitted suggestions after studying experiences that show the tool was used to manipulate stock prices. This comes when there’s a debate about whether the practice helped or harmed economies as managements led by executives with enormous stock options focus on near-term gains, rather than invest in long-term growth of the company.
Economist William Lazonick says share buybacks in the US resulted in boosting per-share earnings and higher stock price, but left with little capacity creation. It is value extraction rather than value creation. In India, where capital is presumably scarce, buyback of shares may be a travesty for most companies. The Sebi consultation paper (bit.ly/3H3s9SS) brings out the fact that share buyback provisions have been more misused than used, exposing gaps, including the proposed phase-out of purchases through stock exchanges, openly used to influence stock prices. The committee proposes to end the stock exchange route for buybacks by April 2025, after concluding this practice to be against the integrity of the markets.
Recommending an increase in the size of the buyback, it says that while a limit of 25% of reserves and paid-up capital can continue to exist, in respect of buybacks undertaken through the open market, the limit can be ‘enhanced for buybacks undertaken through tender offers’. Admission that open-market buybacks are ‘prone to a greater degree of misuse’ makes one conclude that even the tender route is prone to ‘misuse’ but to a lesser degree.
The committee suggests that companies with zero net debt position should be allowed to conduct stock repurchases twice a year instead of once, and that companies buying back stock should not have a capital structure where debt-toequity doesn’t exceed 2:1. While the financial position may be considered a reasonable one to run a company, the question is whether a corporation should be spending its resources to buy back shares instead of repaying debt. If the second buyback could be carried out only by a company with zero net debt, why not the same principle for the first buyback too?
Taxation works against long-term investors who stay invested in companies as they end up paying for those who have sold their holdings in the buyback. Promoters have been benefiting at the cost of minority shareholders. An analysis by the committee shows in 19 of the 68 listed companies that bought back shares, promoters have tendered more than their pre-buyback holding. In these 19 companies, the total tax paid aggregated to Rs 2,988.79 crore, of which the tax paid by these companies on the shares tendered by the promoters was Rs 2,734.35 crore.
On almost all counts, share buyback goes against the basic market principle of price discovery. It legitimises share price-rigging by companies. When fund managers and index managers insist on bigger floats for better price discovery, reducing the float is a sanction to puff up the stock price. Further, the state ends up being a loser in the game of share buybacks. For every Rs 1,000 crore dividend paid, the state receives an estimated Rs 350 crore as tax revenue, barring some holding structures in tax havens. If the same Rs 1,000 crore is used to buy back shares, revenue falls to Rs 230 crore.
While Sebi is reportedly seeking a tweak to the taxation laws, it may be worth considering whether to permit share buyback at all. Conventional dividend payments can protect market integrity as well as encourage companies to invest and create capacities.
It is said to be a way to return cash to shareholders when companies do not have any meaningful investment opportunities for future growth. Historically, excess cash or apart of profits was paid as dividends to equity investors. But share buybacks are beneficial to company executives because share prices rise without any improvement in corporate performance as the number of shares fall, and tax outgo is less. Sebi is now revisiting the rules governing share buybacks. A committee headed by HDFC CEO Keki Mistry has submitted suggestions after studying experiences that show the tool was used to manipulate stock prices. This comes when there’s a debate about whether the practice helped or harmed economies as managements led by executives with enormous stock options focus on near-term gains, rather than invest in long-term growth of the company.
Economist William Lazonick says share buybacks in the US resulted in boosting per-share earnings and higher stock price, but left with little capacity creation. It is value extraction rather than value creation. In India, where capital is presumably scarce, buyback of shares may be a travesty for most companies. The Sebi consultation paper (bit.ly/3H3s9SS) brings out the fact that share buyback provisions have been more misused than used, exposing gaps, including the proposed phase-out of purchases through stock exchanges, openly used to influence stock prices. The committee proposes to end the stock exchange route for buybacks by April 2025, after concluding this practice to be against the integrity of the markets.
Recommending an increase in the size of the buyback, it says that while a limit of 25% of reserves and paid-up capital can continue to exist, in respect of buybacks undertaken through the open market, the limit can be ‘enhanced for buybacks undertaken through tender offers’. Admission that open-market buybacks are ‘prone to a greater degree of misuse’ makes one conclude that even the tender route is prone to ‘misuse’ but to a lesser degree.
The committee suggests that companies with zero net debt position should be allowed to conduct stock repurchases twice a year instead of once, and that companies buying back stock should not have a capital structure where debt-toequity doesn’t exceed 2:1. While the financial position may be considered a reasonable one to run a company, the question is whether a corporation should be spending its resources to buy back shares instead of repaying debt. If the second buyback could be carried out only by a company with zero net debt, why not the same principle for the first buyback too?
Taxation works against long-term investors who stay invested in companies as they end up paying for those who have sold their holdings in the buyback. Promoters have been benefiting at the cost of minority shareholders. An analysis by the committee shows in 19 of the 68 listed companies that bought back shares, promoters have tendered more than their pre-buyback holding. In these 19 companies, the total tax paid aggregated to Rs 2,988.79 crore, of which the tax paid by these companies on the shares tendered by the promoters was Rs 2,734.35 crore.
On almost all counts, share buyback goes against the basic market principle of price discovery. It legitimises share price-rigging by companies. When fund managers and index managers insist on bigger floats for better price discovery, reducing the float is a sanction to puff up the stock price. Further, the state ends up being a loser in the game of share buybacks. For every Rs 1,000 crore dividend paid, the state receives an estimated Rs 350 crore as tax revenue, barring some holding structures in tax havens. If the same Rs 1,000 crore is used to buy back shares, revenue falls to Rs 230 crore.
While Sebi is reportedly seeking a tweak to the taxation laws, it may be worth considering whether to permit share buyback at all. Conventional dividend payments can protect market integrity as well as encourage companies to invest and create capacities.
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
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