SEBI’s proposed buyback rules for leverage limits: to what extent practical? Rules impose low leverage limits for NBFCs and HFCs

 

Pammy Jaiswal

Vinod Kothari and Company

corplaw@vinodkothari.com

Background

As the regulators eye the performance of business houses at the group level for getting a helicopter view of their economic position, many changes have been brought in this direction. Some of which include the requirement of preparing the consolidated results on a quarterly basis, consideration of profitability and other financial statements on a consolidated basis for the purpose of coming up with an IPO under SEBI ICDR Regulations, 2018 and recommendations of the Kotak Committee for making like changes under the Listing Regulations.

SEBI, going forward in the same direction has issued its discussion paper on the proposed changes in the buy-back conditions on 22nd May, 2019[1].  While one of the proposed changes in terms of computing the buy-back size is on the logical side, the other change on taking the debt to equity ratio on a consolidated basis for certain categories of listed companies is seemingly impractical. This note shall cover the brief of the proposed changes and certain extent of critical analysis on the same.

Buy-Back Conditions

Both section 68 of the Companies Act, 2013 (‘Act, 2013’) as well as SEBI Buy-Back Regulations spell out the conditions for buy-back, some of which are as follows:

  • Authorisation in the Articles of Association and the shares subject to buy-back are fully paid-up.
  • Source of funds for buy-back – Three sources are laid i.e. free reserves, securities premium account and proceeds of the issue of any shares or other specified securities.
  • Buy-back offer size – 25% of the paid-up share capital of the company.
  • Buy-back size – Upto 10% of the paid-up share capital and free reserves with the approval of the Board and upto 25% of the paid-up share capital and free reserves with the approval of the members of the company.
  • Debt to equity ratio post buy-back is not more than 2:1 (except for government companies which are NBFCs and HFCs and can have the ratio not exceeding 6:1).
  • Other conditions as mentioned under the SEBI Buy-Back Regulations, 2018 for listed companies going for buy-back.

Both the legislations till now require that these conditions are met on a standalone basis. However, the discussion paper suggests that considering the threshold on standalone basis may not be giving the correct and complete picture of the parent entity which is going got buy-back of its securities.

 

Accordingly, the said paper recommends certain changes which are briefly analysed below.

 

SEBI’s move for conservative computation of thresholds under buy-back

 

Sr. No. Existing Requirement Proposed change Rationale Our comments
1. Board can approve buy-back to the extent of utilising 10% of the paid-up equity capital and free reserves The threshold of 10%  to be considered on conservative basis (both standalone as well as consolidated basis, whichever is lower) ·      Complete overview of group as a whole;

·      Consolidated financials present the economic position of the entity as a whole along with its potential to serve its obligations.

 

Considering the lower of the consolidated and the standalone figures should be absolutely fine as no one will be able to take any advantage out of it, however, the change may adversely affect the buy-back size of the listed company.

 

Especially where the subsidiaries of the listed company have negative net worth, there the limits may substantially go down.

2. Members can approve buy-back to the extent of utilising 25% of the paid-up equity capital and free reserves The threshold of 25%  to be considered on conservative basis (both standalone as well as consolidated basis, whichever is lower) Same as above. Same as above.
3. Post buy-back debt to equity capital to be 2:1 (the debt to capital and free reserves ratio shall be 6:1 for government companies within the meaning of clause (45) of section 2 of the Act, 2013 which carry on Non-Banking Finance Institution activities and Housing Finance activities.) Post buy-back debt to equity capital of 2:1 (the debt to capital and free reserves ratio shall be 6:1 for government companies within the meaning of clause (45) of section 2 of the Act, 2013 which carry on Non-Banking Finance Institution activities and Housing Finance activities) shall be considered on consolidated basis, excluding subsidiaries only if the subsidiaries are regulated and have issuances with AAA ratings

 

Such subsidiaries should have debt to equity ratio of not more than 5:1 on standalone basis

Considering the situation where the subsidiary of the parent entity has large amount of debt in its books, it is not judicious to exclude such debt while computing the debt to equity ratio for the purpose of calculating the buy-back size. This change is not achievable at all considering the following:

·   NBFCs and HFCs are capital intensive;

·   NHB allows 16 times leverage to HFCs;

·   No NBFCs are running at the leverage of 2:1;

·   Even if the parent entity has surplus capital and the same is put in the subsidiary which is capital intensive, the proposition will be flawed; and

·   Considering the inverse relation between weighted average cost of capital (WACC) and leverage, if the funds are given to the subsidiary, the WACC goes up and the leverage comes down.

 

While the above changes have been discussed in the paper, it actually calls for change in the legislation itself which when made effective, will give way to these changes. Till such time, the existing framework shall continue to rule the buy-back exercise.

Whether the aforesaid suggestion is for all listed companies?

Para 4.4 of the discussion paper states that the Primary Markets Advisory Committee (PMAC) of SEBI proposed the changes for those companies which have NBFCs and HFCs as their subsidiaries. This implies that the proposed changes are with the intent of restraining the buy-back exercise for those parent companies which have subsidiaries engaged in the business of financing and therefore, have large exposure on their assets.

Further, this implies that the listed companies whose subsidiaries do not comprise of finance companies may still continue with their practice of considering the threshold at standalone basis unless otherwise mentioned.

Conclusion

While the intent of these changes are aimed to make the buy-back conditions more conservative with an overview on the economic status of the entity on a group level, however, it fails to understand the need for a higher leverage for capital intensive entities.

 

[1] https://www.sebi.gov.in/reports/reports/may-2019/discussion-paper-on-review-of-buy-back-of-securities_43054.html

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