Legalizing Bailout in India: Analyzing Proposal to Sell Shares at a Discount
About the Author: Kopal Mital is a fourth-year BA-LLB (Hons.) student at National Law School of India University, Bangalore.
Image by SalFalko available here.
In March 2022, the Company Law Committee (the “Committee”) released its report recommending changes to the Companies Act, 2013. A bill which will be brought before the Indian Parliament in the winter session will likely include these changes. Proposals introducing fractional shares and changing provisions that govern the role of auditors have dominated the discussion. However, the proposal to ease capital raising requirements for distressed companies is also significant and merits deeper discussion.
This article analyzes the Committee’s proposal, and I argue that before this proposal becomes law, it must clarify the manner in which this policy operates. To that end, this piece proposes a series of recommendations and safeguards to address the practical issues of this proposal to ensure smoother implementation.
Summary of the Committee’s Proposal
The proposal’s intention stems from COVID-19’s impact on many businesses. According to a survey conducted by the Federation of Indian Chambers of Commerce & Industry, COVID-19 impacted 50% of companies' operations and 80% of companies reported cash flow losses. Recognizing that companies were experiencing difficulties in raising new capital, the Committee proposed enabling certain distressed companies working in public interest to sell their shares to the federal and state governments at a price below nominal value. Nominal value is the value maintained as an entry in a company’s accounting books. The proposal defined “distressed companies” as those facing a cash loss for the last three successive years.
The proposal seeks to carve out an exception to the rule established under section 53 of Companies Act, 2013, which prohibits companies from selling their shares below nominal value. The rule also prescribes criminal penalties, including fines and imprisonment, to punish violations.
Legalizing Bailout in India
Businesses and society are mutually dependent. Businesses produce goods and services and generate employment for society. Therefore, this injection of capital into businesses as a bailout is a welcome move. While “bailout” has many definitions, its common interpretation is government payments to certain “liquidity constrained private agents.” Equity investment is one form of bailout that the Committee proposed. In cases where private agents need liquidity immediately and cannot afford to take on the additional obligations of repaying interest and principal amounts that come with taking a loan, equity investment is more desirable. Given that COVID-19 impacted many companies’ cash flows, many businesses are cash strapped and unable to make the repayments. Therefore, equity purchases have been proposed. Governments are well positioned to purchase equity from struggling businesses because they are equipped with the resources and ability to mobilize them. However, taxpayers’ money finances these bailouts. Therefore, bailouts must be well-thought out.
Since governments bail out companies using taxpayer money, efficient use of resources is of paramount importance. To ensure the optimum use of resources, implementation details are key. An effective manner of designing implementation details could be to institute checks and balances at every stage of the bailout.
The Committee’s proposal does not flesh out the details. The report notes that further terms and conditions would be mentioned in the rules that would be drafted by the federal government. Therefore, there is a lack of clarity about the modalities of implementation. If enacted, this proposal would effectively legalize government bailout, making it even more crucial that the proposal contain concrete implementation details.
Stages of Bailout
Bailouts have three stages: pre-investment, investment, and disinvestment. The third stage is important because bailouts should be short-term, as the government’s primary function is not to run businesses. Only extreme circumstances warrant government intervention to ensure businesses do not collapse altogether. After the government recovers its investment, it must disinvest.
Stage 1: Strict and Clearly Defined Eligibility Criteria
The current proposal outlines two criteria. First, only companies that have faced a cash loss consistently for the last three years would be eligible. Cash loss can be indicative of fraud and mismanagement. However, given the impact of COVID-19 and lockdown restrictions, cash loss could be the result of the drop in demand and supply of goods. Companies would still need to maintain their production facilities and pay their workers. Therefore, this measure accounts for the COVID-19 induced impact of the macroeconomic factors on businesses.
Second, the company must work in public interest. Given the breadth of this category, it will provide the government with the flexibility to invest in a wide range of companies.
While these aspects are important, the government should consider additional factors when deciding to invest in a company.
First, the government should only invest in solvent companies that are currently facing a cash crunch. Keeping in mind the limited resources, it is important that the government assists those firms which can return to making profits. “Zombie firms” or firms that have dim prospects of recovery should be avoided.
Second, the government should ensure that the company’s management is financially disciplined. This is essential to reduce the likelihood of the management misusing the investment funds. Therefore, the government must carry out due diligence and review the financial statements of the company.
Third, there should be minimal political interference in the allocation process. Privileging political consideration may lead to inefficiencies and waste of limited resources. For optimal use of resources, the funds should go to companies that are projected to recover and grow. To this end, the government must avoid conflicts of interest and make appropriate interest disclosures. Further, the arm’s length principle should be followed, meaning that transactions with related parties should be carried out as if they were unrelated.
Stage 2: Accountability Mechanisms During the Course of Investment
An important lesson learnt from past bailouts is that oversight is necessary. In the absence of oversight mechanisms, there would be high agency costs. The proposal offers two mechanisms. First, the government should be a part of the management by having a seat on the board of directors. If that is not possible, then they must be observers. Both are effective ways of exercising control over the management.
These mechanisms should be supplemented with period performance reviews and examinations of audited financials to ensure the judicious use of the investment. Second, the funding allocation should be done in rounds. This would allow the government to learn from the mistakes of the previous round. This would also allow the government to understand the right level of intervention. An escrow mechanism could also be adopted, whereby the funds would only be credited if the parties have fulfilled certain predetermined obligations.
Stage 3: Disinvestment
As highlighted before, the government’s intervention should be temporary. By making the assistance long-term, there is a risk of accumulating “dead capital,” which creates pressure on the national economy. To avoid such a situation, there should be a clear exit plan. The government should withdraw when certain predetermined objective goals of profit and growth are met. An alternative to this could be that the government disinvests after a fixed period of time. To ensure further accountability, a condition could be that if the government is unable to recover its initial investment after the investment term expires, the difference in funds would be paid back by the directors of the company.
Given that the Committee’s recommendations may become law, it is important to ensure that the nuances of implementation are deliberated. If this proposal becomes law, its impact will not be limited to the aftermath of COVID-19. Therefore, the bill should be designed in a way that accounts for the long-term impact of legalizing the bailout. By instituting multiple checks and balances at every stage, the bailout will hopefully be more targeted and therefore, more effective.
The author would like to thank Mr. Rajesh Arora (Head of Finance, Al Hilal Bank, Abu Dhabi) for his insights.