Keywords: Demerger, Companies Act 2013, Company Examples, Corporate restructuring
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Keywords: Demerger, shareholder value, corporate, corporate restructuring, Jio Demerger
(Dhruv Thakur is a IV year, B.B.A.LL.B student at Gujarat National Law University, GNLU)
INTRODUCTION:
Companies have now figured out that a diversified business model under one listed entity fails to attract the required valuation. In the previous decade, India witnessed a trend where companies rambled diversification drives beyond their central businesses. However, in today’s era, there is a clear inclination towards value unlocking by demerging business units which indicates many of them have now realized that the diversified business model does not work well in terms of stock valuations and fundraising compared to companies which stayed focused on their core businesses. But the question is whether in the last few years demergers have created value for shareholders? Before diving into that it is important to get familiarized with the fundamental idea behind a demerger.
DEFINITION AND RATIONALE OF A DEMERGER:
A Demerger is essentially separation of one or more units of a company to either be liquidated or form a new company independent from the original one. Primarily, demergers are a form of corporate restructuring the objective behind which is to promote specialization. Sections 230 to 240 of Chapter XV of the Companies Act, 2013 (hereinafter ‘CA, 2013’) read with the Companies (Compromises, Arrangements and Amalgamations) Rules, 2016 are the applicable provisions in case of a demerger. The term ’demerger’ is not defined under the CA, 2013 per se but explanation to Section 230 (1) allows for division of shares of different classes as a route for the readjustment of share capital. Section 2 (19AA) of Income Tax Act, 1961 (hereinafter ‘IT Act’)defines a demerger as-
However, it was held by the High Court of Delhi in the matter of Indo Rama Synthetics Ltd. that the definition under the IT Act was only for the mere purpose of making sure that the demerger was tax neutral, irrespective of whether it fulfills other conditions as regarded by the IT Act.
The rationale behind pursuing demergers is based on the many benefits if offers, which works as motives for a company to initiate the process. It allows a specific division or unit to grow as a separate and focused entity, thereby increasing its efficiency and effectiveness.
To illustrate better, Reliance Jio Infocom Ltd. (hereinafter ‘RJI’) which had three primary undertakings namely (a) digital services business, (b) optical fibre business, and (c) tower infrastructure business went for an NCLT approved demerger process in 2019. It transferred the optical fibre business to a newly formed company ‘Jio Fibre Pvt Ltd.’ and the tower infrastructure business to an existing company ‘Reliance Jio Infratel Pvt Ltd’. However,the digital services business was retained with the original company (RJI).
Companies have now figured out that a diversified business model under one listed entity fails to attract the required valuation. In the previous decade, India witnessed a trend where companies rambled diversification drives beyond their central businesses. However, in today’s era, there is a clear inclination towards value unlocking by demerging business units which indicates many of them have now realized that the diversified business model does not work well in terms of stock valuations and fundraising compared to companies which stayed focused on their core businesses. But the question is whether in the last few years demergers have created value for shareholders? Before diving into that it is important to get familiarized with the fundamental idea behind a demerger.
DEFINITION AND RATIONALE OF A DEMERGER:
A Demerger is essentially separation of one or more units of a company to either be liquidated or form a new company independent from the original one. Primarily, demergers are a form of corporate restructuring the objective behind which is to promote specialization. Sections 230 to 240 of Chapter XV of the Companies Act, 2013 (hereinafter ‘CA, 2013’) read with the Companies (Compromises, Arrangements and Amalgamations) Rules, 2016 are the applicable provisions in case of a demerger. The term ’demerger’ is not defined under the CA, 2013 per se but explanation to Section 230 (1) allows for division of shares of different classes as a route for the readjustment of share capital. Section 2 (19AA) of Income Tax Act, 1961 (hereinafter ‘IT Act’)defines a demerger as-
“Demerger”, in relation to companies, means the transfer, pursuant to a scheme of arrangement under sections 391 to 394 of the Companies Act, 1956 (1 of 1956, old act), by a demerged company of its one or more undertakings to any resulting company…”
However, it was held by the High Court of Delhi in the matter of Indo Rama Synthetics Ltd. that the definition under the IT Act was only for the mere purpose of making sure that the demerger was tax neutral, irrespective of whether it fulfills other conditions as regarded by the IT Act.
The rationale behind pursuing demergers is based on the many benefits if offers, which works as motives for a company to initiate the process. It allows a specific division or unit to grow as a separate and focused entity, thereby increasing its efficiency and effectiveness.
To illustrate better, Reliance Jio Infocom Ltd. (hereinafter ‘RJI’) which had three primary undertakings namely (a) digital services business, (b) optical fibre business, and (c) tower infrastructure business went for an NCLT approved demerger process in 2019. It transferred the optical fibre business to a newly formed company ‘Jio Fibre Pvt Ltd.’ and the tower infrastructure business to an existing company ‘Reliance Jio Infratel Pvt Ltd’. However,the digital services business was retained with the original company (RJI).
Each of the three undertakings do have a distinct strategy, separate industry specific risks and operate inter alia under differentiated market dynamics. Even the competition involved in each of the businesses is different from the other two. Hence, segregation of the company by a demerger will incorporate enhanced focus of each of the undertakings and help exploit varied opportunities in their respective fields. Here’s a link to RJI’s composite scheme of arrangement.
Further, in a few cases of family owned companies, demergers are also used to give effect to family partitions, for instance the division of Ambani Group in 2013 between Anil and Mukesh Ambani, splitting up Reliance Industries Ltd. into four distinct entities.
WAYS TO GIVE EFFECT TO A MERGER:
Agreement between the promoters
Under this case a company may hive off its undertaking to a new resulting company. This new company formed due to the demerger issues shares of the resulting company to shareholders of the parent company as consideration. The assets and liabilities pertaining to the undertaking which has been demerged will be transferred to the new resulting company.
2. Demerger under the scheme of arrangement
Similar to the amalgamation process, in this case approval from the NCLT, under CA, 2013 is mandatory. Provisions governing this route are Sections 230-232 of the CA, 2013. However, this route is only permissible if the Memorandum of Association (hereinafter ‘MoA’) and Articles of Association (hereinafter ‘AoA’) of the company allow for such a process. If not, then the first step would be to amend the AOA of the company by passing a special resolution in the general meeting.
3. Demerger under voluntary winding up and the power of liquidator
After the split of the original company into various companies, the original company can go for voluntary winding up under Section 270 of the CA, 2013. Original company may transfer or sell its workings to the resulting companies.
DEMERGERS AND SHAREHOLDERS' VALUE:
Demergers benefit the shareholders of the company by providing them shares of the applicant company (which is going for the demerger) as well as the resulting company (company segregated from applicant company), which in turn divests better opportunities to participate in the management, decision making process, operations and profits.
But is shareholder value in practice enhanced by demergers and spin-offs? It depends and needs to be carefully examined, as with everything else in life. It is a well-known fact that one of the major objectives behind demergers is to increase the shareholder value. Disposal of any undertaking, will replace cash and/or securities for assets. The benefits to shareholders are mightily dependent on the reaction of the stock market. The typical situation is where the subsidiary is in a high rated sector (rated highly by the market) and the seller is outmoded. Then as an inevitable result demerger unlocks the hidden value for shareholders who receive a part in the demerged equity.
To give an example, in 2016 Crompton Greaves through a court approved process demerged its consumer product business into a separate listed company ‘Crompton Greaves Consumer Electrical’. Consequentially, shareholders of Crompton Greaves were issued shares in the resulting company, The result of the arrangement was a 57% combined return of both original and resulting undertaking since its record date on March 16, 2016.
CONCLUSION:
Well, ideally shareholders of the demerged undertakings do reap the benefits of higher focussed businesses with management accountability driving the intrinsic value of each company, propelling their respective share prices higher than had they remained a combined entity. And spin-offs are usually preferred over IPOs by investors due to their assets being better known and better positioning of incentives due to the parent company’s wish for the progeny to succeed. That being said, have spin-offs underachieved after being demerged?
Further, in a few cases of family owned companies, demergers are also used to give effect to family partitions, for instance the division of Ambani Group in 2013 between Anil and Mukesh Ambani, splitting up Reliance Industries Ltd. into four distinct entities.
WAYS TO GIVE EFFECT TO A MERGER:
Agreement between the promoters
Under this case a company may hive off its undertaking to a new resulting company. This new company formed due to the demerger issues shares of the resulting company to shareholders of the parent company as consideration. The assets and liabilities pertaining to the undertaking which has been demerged will be transferred to the new resulting company.
2. Demerger under the scheme of arrangement
Similar to the amalgamation process, in this case approval from the NCLT, under CA, 2013 is mandatory. Provisions governing this route are Sections 230-232 of the CA, 2013. However, this route is only permissible if the Memorandum of Association (hereinafter ‘MoA’) and Articles of Association (hereinafter ‘AoA’) of the company allow for such a process. If not, then the first step would be to amend the AOA of the company by passing a special resolution in the general meeting.
3. Demerger under voluntary winding up and the power of liquidator
After the split of the original company into various companies, the original company can go for voluntary winding up under Section 270 of the CA, 2013. Original company may transfer or sell its workings to the resulting companies.
DEMERGERS AND SHAREHOLDERS' VALUE:
Demergers benefit the shareholders of the company by providing them shares of the applicant company (which is going for the demerger) as well as the resulting company (company segregated from applicant company), which in turn divests better opportunities to participate in the management, decision making process, operations and profits.
But is shareholder value in practice enhanced by demergers and spin-offs? It depends and needs to be carefully examined, as with everything else in life. It is a well-known fact that one of the major objectives behind demergers is to increase the shareholder value. Disposal of any undertaking, will replace cash and/or securities for assets. The benefits to shareholders are mightily dependent on the reaction of the stock market. The typical situation is where the subsidiary is in a high rated sector (rated highly by the market) and the seller is outmoded. Then as an inevitable result demerger unlocks the hidden value for shareholders who receive a part in the demerged equity.
To give an example, in 2016 Crompton Greaves through a court approved process demerged its consumer product business into a separate listed company ‘Crompton Greaves Consumer Electrical’. Consequentially, shareholders of Crompton Greaves were issued shares in the resulting company, The result of the arrangement was a 57% combined return of both original and resulting undertaking since its record date on March 16, 2016.
CONCLUSION:
Well, ideally shareholders of the demerged undertakings do reap the benefits of higher focussed businesses with management accountability driving the intrinsic value of each company, propelling their respective share prices higher than had they remained a combined entity. And spin-offs are usually preferred over IPOs by investors due to their assets being better known and better positioning of incentives due to the parent company’s wish for the progeny to succeed. That being said, have spin-offs underachieved after being demerged?
A few definitely have. All things considered, one thing is for certain, be it Crompton Greeves 2016 demerger (57% combined return) or Reliance Jio Infocom’s 2019 demerger, the value generated for shareholders is positively reflected in the market price of the demerged and resulting corporate entities where the split in undertakings is well defined and better thought out.
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