Dubious uses of share buyback: Why Infosys' former execs are out of place

Ever since buyback was allowed by the Indian company law more than a decade ago in a spirit of me-too, it has elicited mixed reactions and responses. The US was to kick off this rather questionable practice - questionable because it upsets the order of priority in the matter of pay back of capital.

Creditors have always had priority both when a company is a going concern as well as when it is wound up. But buyback of shares amounts to preferring shareholders ahead of creditors and that precisely is its most obnoxious feature.

The US model of buyback is even more reprehensible in that it allows the shares bought back to be kept as investments thus fostering the worst form of insider trading.

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Indian promoters fearing takeover exulted when buyback was permitted. They bought back shares not in altruistic interest but in their own enlightened selfish and narrow interest. To wit, if a promoter was quaking in his boots with just a 20 percent stake, he asked his company to buy back say 20 percent. This enables him increase his stakes to 25 percent without shelling out one rupee! Earlier he held 20 out of 100 but now he holds 20 out of 80.

While the Indian law did not go overboard like the US law on the issue in permitting the shares bought back to be used in treasury operations, it did allow shares to be purchased from the market or proportionately from each shareholder. The former course deprived shareholders who did not go the market high and dry given the fact that in an open offer democratically made to all the shareholders the offer price is much higher than the market price. It is good that our law now frowns on open market purchases and insists on proportionate public offer to be made on buyback.

The moot question, however, is why countenance buyback at all when a company can distribute the same amount as cash dividend. Companies prefer the buyback route of returning surplus idle cash to shareholders because the income tax law does not demand its pound of flesh.

Simply put, the income tax law says buyback under the framework of the company law does not amount to distribution of dividend and hence no distribution tax is payable by a company resorting to buyback of its own shares. Cash dividend, on the other hand, exposes a company to dividend distribution tax. Buyback, however, exposes the shareholders to capital gains tax but companies believe that the shareholders are tax-savvy enough to insulate themselves from tax liability by using tax shelters.

Those recommending Infosys buying back its own shares by using its formidable cash reserves have not only tax calculus before them: Buyback also results in reduction of share capital. In future, the company will have to service the capital thus truncated or pruned whereas if the dividend route were adopted, it will have to service a rather large capital, with capital remaining as it was pre-dividend.

The disquieting bottom lines of buyback are the following:

Creditors’ security is reduced to the extent capital is reduced

The law requires only the nominal capital to be transferred to buyback reserve. To wit, should Infosys buyback each Rs 5 share at Rs 3,000, only Rs 5 per share needs to be transferred to buyback reserve. This is ridiculous given the fact that the shareholders have gotten back lion’s share of their funds relegating creditors to an insecure spot.

Shareholders themselves are fobbed off

They should hold out for greater rewards by insisting on dividend rather than buyback. Buyback ousts them to the extent shares have been bought back whereas they stay put as they were in case dividend were to be distributed instead. In this sense buyback is as reprehensible as delisting of shares. Both are anti-minority shareholder.

Thus the raison d’tre of buyback has always been its mischief potential, be it rubbing the creditors and minority shareholders on the wrong side or catering to self-preservation instincts of promoters. The altruistic spin sought to be given to buyback simply does not wash.