A STEP IN THE RIGHT DIRECTION: A critical commentary on the latest amendments to the Companies Ordinance, 1984

A STEP IN THE RIGHT DIRECTION: A critical commentary on the latest amendments to the Companies Ordinance, 1984

By Khurram Rashid, Bar‑at‑Law, Karachi

Epilogue:

Until recently, there was a prohibition on 'companies to buyback their own shares or provide loan/assistance to someone else to buy such shares, section 95 of the Companies Ordinance, 1984 (the "Ordinance") expressly prohibited re‑purchases of this nature and stipulated penalties not only for the company in breach of the provision, but also all its officers who knowingly and wilfully allowed the company to effect the 'buyback', or provided financial assistance to enable some other person to buy such shares.

The Finance Act, 1999 (the "Finance Act") has now amended the above‑referred provisions by allowing the listed companies to purchase their own shares under specified procedure. Given that the power to buyback has come to be understood in all the leading corporate law jurisdictions in the world as essential for the companies' growth and better maintenance in general, and cardinal for capital markets' future, the latest amendments to the Ordinance certainly have a lot to be applauded for.

The background to the amendments:

The traditional reason behind the prohibition on companies to buy their own shares has been two‑fold: firstly, a buyback of this nature inevitably amounts to capital reduction, for which there are express provisions in the Ordinance, requiring the approval of the Court. Accordingly, it is arguable that allowing an 'indirect' reduction by way of share repurchasing would facilitate, at the cost of the investors, the circumventing of the mandatory Court's approval requirement. Secondly, such transactions may also lead to "trafficking" by the company in its own shares, thereby allowing the company to play havoc with the potential shareholders.

Concerns of similar nature had prevented even the European and American corporate law regimes to allow buybacks for a long time. However, in the early eighties, the English Parliament signed the Companies Acts of 1981 and 1985 into law. The effect of these statutes was to make it valid and legal for English Companies to repurchase their own shares. Similarly, the advent of 'modern' corporate statutes in Canada, such ‑as the Canada Business Corporations Act, 1974‑5‑6 and the Ontario Business Corporation Act, 1982, allowed for such share repurchases in Canada as well. In the USA, the legislators took the idea even further, and allowed US Companies to have 'treasury shares', i.e., shares that may be resold by the company upon their repurchase.

The reason for the shift in perception was simple: it was realised that the advantages of allowing buybacks far outweighed the disadvantages. At first glance, a buyback may seem objectionable for the above‑referred reasons, but most of these concerns dissipate when the overall utility of the buyback powers, coupled with appropriate checks to prevent capital reduction and illegal 'trafficking', are taken into account. Empirical studies in the West have indicated that stock markets greet the announcement of a buyback with significant stock price increase, as such announcements are seen as a reliable signal that the company perceives its shares to be undervalued. Stock prices go up, and an overall benefit is accrued to all the non‑selling shareholders of the company.

In the same vein, share repurchase strategies may also be used as a technique of signalling hidden company value to the market. Apart from the general advantages of more efficient stock markets in moving capital to its most highly valued users, this also reduces deadweight losses associated with information production which would be incurred by market intermediaries were buybacks prohibited. It is for these reasons that share repurchases are also useful in stabilizing speculative markets during crashes. Corporate buyback announcements, for example, were an important reason for the revival of the US market after its crash in 1987.

Share repurchases may also be adopted as a defensive strategy in a take‑over bid. When an 'insurgent' seeks to acquire control of a 'target' company, the target may seek to 'chill' the take‑over by competing with the insurgent in the purchase of its shares. Of course, in appropriate cases the target may even repurchase the shares held by the insurgent in order to remove a pesky shareholder ("greenmail strategy").

Share repurchases may, however, be motivated by benign considerations too. The repurchase may, for example, amount to a disinvestment strategy by a company with surplus cash flow after all profitable opportunities have been taken up. Obviously, in such cases, the company may also decide to return the surplus cash to shareholders through a cash dividend, but often the company's clientele of investors would prefer share repurchases to cash dividends because of tax considerations.

The Finance Act. 1999 (the "Finance Act"):

While the winds of changes were blowing across much of the corporate world, no such change seemed to be in the offing in Pakistan, and section 95 of the 1984 Ordinance continued to impose penalties for buyback transactions. In view, however, of the replaced cognition in most of the corporate world, section 95 prohibitions seemed all but anachronistic.

In this backdrop, the Finance Act finally administered elixir of sorts to our rather obstinately indisposed corporate law structure. Section 14 of the Finance Act amends the Ordinance by, inter alia, replacing section 95(4) with an amended version thereof, and inserting a wholly new section (section 95‑A) therein. These new provisions allow the listed companies to purchase their own shares under specified procedure. The Finance Act has also allowed companies in general to have any type of share capital they wish subject, however, to certain specified rules, and to reserve a percentage of newly issued shares for their employees under the employees stock option schemes.

So, a Pakistani listed company may now decide to buyback its own shares through a special resolution, which must specify the maximum number of shares to be purchased, alongwith the maximum price payable and the period within which such purchase may be made. More importantly, the purchase must be in cash and only out of the 'distributable profits'. Further, the directors must make a declaration of solvency before the company could make such a purchase. If these formalities are not complied with, the company and all its concerned officers will be liable to a fine that may extend to one million rupees. The officers may, in addition, be liable to imprisonment for up to six months.

Dissecting the amendments:

The new section 95‑A addresses the issue of potential capital reduction from the repurchase by stipulating firstly, that the repurchase must be made out of distributable profits only, and secondly, by making a provision for a new statutory reserve by the. name of 'Capital Repurchase Reserve Account' ("CRRA"). The idea is simple. Since the repurchased shares are to be cancelled, the paid‑up capital would inevitably be reduced. However, by requiring the company to transfer from the distributable profits a sum equal to the amount thus, reduced to the CRRA, the reduction in the capital is effectively offset. Further, cases where the repurchase has been made at a lower price than the nominal value of the shares repurchased, the CRRA will also be credited with the 'difference amount'. This additional reserve will obviously serve as an added security for the company's creditors.

To make sure that the directors or the 'creative accountants' of the company do not indulge in 'soft transactions' by allowing only the shares of their 'preferred' shareholders to be repurchased, section 95‑A(9) requires the repurchase to be through a tender system. The mode of tender is to be decided in general meeting through a special resolution. Lastly, a repurchase will also trigger the traditional Companies Ordinance prophylactic, which requires maintaining of a register of shares and filing of returns with the Registrar.

All these precautions certainly would help address the potential capital reduction issue and would curb any abuse of the process to a major extent, but then there is always room for improvement. Unfortunate though as it is, the 'room' in the instant matter may well be too big for the provisions to have any real teeth.

The most obvious flaw that triggers an immediate concern is the apparent sufficiency under the provisions, as drafted, of the directors' declaration of solvency for the purposes of proceeding with a proposed buyback. Alarmingly, while the provisions require the said declaration to be supported by an affidavit, they do not impose any penalty for directors who would make the declaration and a supporting affidavit, but only fraudulently! More importantly, the new provisions do not require the directors or the sellers of the re‑purchased shares to make good any loss to the company in case of an illegal re‑purchase. In such a case, since the board will have complied with the new section 95‑A by making the declaration supported by affidavit (albeit fraudulently), the section 95‑A(14) penalty would not even apply to them. Further, even if the directors are somehow made liable for the fraud (under the already existing provisions of the Ordinance), the company would still not benefit from it in monetary terms, much to the distress of its creditors.

False Declaration

The above result follows directly from the fact that the penalty under section 95‑A(14), when viewed in this context, is simply for failing to make a declaration supported by an affidavit. Presumably, therefore, if the directors satisfy this requirement, even in a .fraudulent manner, they will not be liable under sub‑clause (14) of the provision. Of course, one may argue that in such cases, section 492 of the Ordinance will come into play and the directors will be liable for the penalty prescribed under that provision. However, such an argument would ignore the fact that while in terms of imprisonment, section 492 is definitely more 'deterring' than section 95‑A, but in terms of the fine, section 492 only specifies a maximum fine of Rs.20,000, which when compared with one million rupees under section 95‑A is an embarrassingly tiny amount. It is indeed strange that if the directors simply fail to make a declaration, for which there may be any number of innocent reasons, they will be liable to pay up to one million rupees in fine, but if they intentionally and with the intention to defraud all concerned, produce a false declaration and/or affidavit, they may only be liable to pay twenty thousand rupees!

An interesting solution may be found under the English law, which states that in case a private company uses its capital to effect a repurchase, the directors must make a declaration of solvency (same requirement as under the new amendments). However, if the company goes into insolvency within a year of its directors having made the declaration of solvency, the directors as well as the seller of the shares are responsible to make good the loss to the company. Perhaps, even a better alternative may have been section 362 of the Ordinance itself, which deals with directors' declaration of solvency in cases of members' voluntary winding‑up. There too, the declaration is to be accompanied by an affidavit, but more appropriately, such a declaration must be supported by an auditors' report. Even more importantly, subsections (3) and (4) of this provision specifically deal with false declarations, by stating that in such cases, the directors are liable to six months' imprisonment and/or fine of up to Rs.10,000 (the quantum, unfortunately, is again inappropriate). Further, if the company goes into insolvency within a year of effecting the declaration, it will be deemed that the directors did not have reasonable grounds for their opinion. It is very surprising indeed that the draftsman and those instructing him chose to ignore this provision which is contained in the Ordinance itself.

Remedy For the Company?

It is of course possible for the directors to base their decision to effect a repurchase on an erroneous understanding of the company's position, as seen through their rose‑tinted glasses. More importantly, the decision may even be made pursuant to the directors' own fraudulent designs. In these instances, while the directors themselves may be handed the specified penalty in section 95‑A(14), they will not be accountable to the company for any loss that the company may have suffered due to their said decision. Surely, there is no reason why the company should be deprived of an effective remedy in such cases, as it is rudimentary law that companies ought to be protected from the debauchery of their fraudulent directors.

It may, however, be argued that the above‑referred 'lacunae' under the new provision is intentionally ignored by the drafters since the directors are liable to the company in any case under the 'fiduciary duty principle'. Effectively, what this principle means is that the directors are under a duty to always act in the best interests of 'the company, and are accountable to the company for any action on their part which is not uberrimae fidei, i.e., in extreme good faith. This is undoubtedly true, but in practice, it is unlikely that any action will be taken against the board by the company unless there is a change in those controlling the company or unless it goes into liquidation, administration or receivership. Moreover, proving a breach of fiduciary duty is not very easy either, since the Courts are quite wary of interfering with the directors' decision. This is all the more so where the decision is prima facie bona fide.

A little matter of 'Financing' the repurchase:

Another oversight on the part of the draftsman is the fact that a buyback may just as easily be effected by a company merely by providing financial assistance to someone else for the purposes of purchasing its own shares. In such cases, the company does not make a direct re‑purchase but the consequences for the creditors are, in effect, just the same, i.e., the assets otherwise available to the company/members/creditors get utilized for financing the re‑purchase. Given the availability of these indirect means of making a buyback, it is important that the same restrictions that apply to direct re‑purchases are also applied to financing transactions of this nature. Unfortunately, this has not been done and section 95(3) of the Ordinance continues to impose a picayune penalty of Rs.2,000 for such transactions (Rs.10,000 for listed companies). In view of the huge difference between the penalties for direct and indirect re‑purchases that we now have, it will not be very surprising if the companies actually feel encouraged to adopt the indirect financing method for repurchases, thus, bypassing all the prophylactics of section 95‑A.

Conclusion:

The permission to listed companies to buy their shares is certainly a step in the right direction. However, the midnight oil burnt on drafting the amendments could have achieved even more if the occasions when the amended provisions would bite were carefully determined. The requirement for a declaration of solvency, supported by an affidavit, is obviously absolutely vital for the whole buyback scheme, but then it looses its utility if the directors are allowed to con their way through it.

It is submitted, therefore, and given the potential of abuse that is inherent to the process of buyback, that the directors who fraudulently make the declaration of solvency and the seller of the shares so repurchased should both be made personally liable to the company, beside any other criminal liability as envisaged by the amended provisions. Further, the penalty for companies providing financial assistance to enable someone else to purchase its share should also be brought in line with those imposed for a direct repurchase.

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