The Bright Side of Divestment

An entrepreneur may strategize his business either by expansion or by way of restructuring of assets and business divisions to cement the optimal structure of its organization. In expansion or restructuring, a firm acquires or sells a running business or assets and what we have is an overnight restructured commercial venture through combinations.

These combinations are in the form of mergers, demergers, divestments, acquisitions, amalgamations and takeovers and have now become important features of corporate restructuring. They have been playing an important role in the external growth of a number of leading companies across the world which is discussed here.

Divestment and its Types

A divestment could legally come in the categories of demerger, slump sales, spin offs, hive offs, and disinvestments. Most of these work differently or similarly in the legal and commercial spheres.

Merger/Demerger

A merger or a demerger is a combination of two or more businesses into one business. Laws in India use the term 'amalgamation' for merger. The Income Tax Act,1961 [Section 2(1A)] defines amalgamation as the merger of one or more companies with another or the merger of two or more companies to form a new company, in such a way that all assets and liabilities of the amalgamating companies become assets and liabilities of the amalgamated company and shareholders not less than nine-tenths in value of the shares in the amalgamating company or companies become shareholders of the amalgamated company.

The transferring company is getting divested and the transferee company is acquiring. Thus, the above may take two forms:-

1. Merger/Demerger through Absorption:- An absorption is a combination of two or more companies into existing companies. All companies except one lose their identity in such a merger.
2. Merger/Demerger through Consolidation:- A consolidation is a combination of two or more companies into a 'new company'. In this form of merger/ demerger, all companies are legally dissolved and a new entity is created. Here, the acquired company transfers its assets, liabilities and shares to the acquiring company for cash or exchange of shares. Besides, there are three major types of mergers/demergers:-
3. Horizontal merger:- It is a combination of two or more firms in the same area of business.
4. Vertical merger:- It is a combination of two or more firms involved in different stages of production or distribution of the same product. Vertical merger may take the form of forward or backward merger. When a company combines with the supplier of material, it is called backward merger and when it combines with the customer, it is known as forward merger.
5. Conglomerate merger:- It is a combination of firms engaged in unrelated lines of business activity.

Slump Sale

'Slump sale' is nothing but transfer of a whole or part of business concern as a going concern; lock, stock and barrel. As per S. 2(42C), introduced by the Finance Act, 1999, 'slump sale' means the transfer of one or more undertakings as a result of the sale for a lump sum consideration without values being assigned to the individual assets and liabilities in such sales. 'Undertaking' has the same meaning as in Explanation 1 to S. 2(19AA) defining 'demerger'.

Explanation 2 to S. 2(42C) clarifies that the determination of value of an asset or liability for the payment of stamp duty, registration fees, similar taxes, etc. shall not be regarded as assignment of values to individual assets and liabilities. Thus, if value is assigned to land for stamp duty purposes, the transaction will not cease to be a slump sale. 1. The subject matter of slump sale shall be an undertaking of an assessee. 'Undertaking' is defined as per Explanation 1 to S. 2(19AA), which includes a division. S. 50B provides for computation of capital gains on slump sale of 'undertaking or division'. The word 'division' is nowhere defined in the slump sale provisions.

Also, it is not clear as to how a 'division' is distinct from an 'undertaking' and how important is that distinction for the purpose of S. 50B. 2. An 'undertaking' may be owned by a corporate entity or a non-corporate entity, including a professional firm. This is on account of the following: (a) S. 50B refers to 'assessee' without any specific exclusion of a non-corporate entity. Sale of entire business undertaking by a firm to a company as a going concern was held to be a slump sale [Industrial Machinery Associates v. CIT, [81 ITD 482 (Ahd.)]. (c) As per dictionary, 'undertaking' is defined as 'a body corporate, partnership or an unincorporated association carrying on trade or business with a view to making profit'. 3. Slump sale may be of a single undertaking or even more than one undertaking. 4.

The undertaking has to be transferred as a result of sale. If an undertaking is transferred otherwise than by way of sale, say, by way of exchange, compulsory acquisition, extinguishment, inheritance by will, etc., the transaction may not be covered by S. 2(42C). This is because the definition of 'transfer' in S. 2(47) specifically lays down the different modes which shall be regarded as transfer. 'Sale' is just one of them. Slump sale is restricted only to 'transfer as a result of sale'. 5. The consideration for transfer is a lump sum consideration. This consideration should be arrived at without assigning values to individual assets and liabilities.

Spin offs and or Hive offs

It is the creation of an independent company through the sale or distribution of new shares of an existing business/ division of a parent company. A spinoff is a type of divestiture. Businesses wishing to 'streamline' their operations often sell less productive or unrelated subsidiary businesses as spinoffs. The spun-off companies are expected to be worth more as independent entities than as parts of a larger business.

Disinvestment and PSEs

In India for almost four decades the country was pursuing a path of development in which public sector was expected to be the engine of growth. However, the public sector had overgrown itself and their shortcomings started manifesting in the shape of low capacity utilization and low efficiency due to over manning and poor work ethics, over capitalization due to substantial time and cost overruns, inability to innovate, take quick and timely decisions, large interference in decision making process etc.

The Government started to deregulate the areas of its operation and subsequently, the disinvestment in Public Sector Enterprises (PSEs) was announced. The process of deregulation was aimed at enlarging competition and allowing new firms to enter the markets. The market was thus opened up to domestic entrepreneurs / industrialists and norms for entry of foreign capital was liberalized. This was the process of Disinvestment in India.

Divestment as a Stretegic Tool

The most common motives and advantages are:-

Accelerating a company's growth, particularly when its internal growth is constrained due to paucity of resources.

Enhancing profitability because a combination of two or more companies may result in more than average profitability due to cost reduction and efficient utilization of resources. This may happen because of:-

• Economies of scale:- This arise when increase in the volume of production leads to a reduction in the cost of production per unit.
• Operating economies:- This arise because a combination of two or more firms may result in cost reduction due to operating economies. This helps in overall setting up of effective distribution systems, enhances marketing strategies and boosts research and development activities.
• Synergy:- This implies a situation where the combined firm is more valuable than the sum of the individual combining firms. Operating economies are one form of synergy benefits.
• Diversifying the risks of the company, particularly when it acquires those businesses whose income streams are not correlated. Diversification implies growth through the combination of firms in unrelated businesses. It results in reduction of total risks through substantial reduction of cyclicality of operations.

A merger may result in financial synergy and benefits for the firm in many ways:-

• By eliminating financial constraints.
• By enhancing debt capacity. This is because a merger of two companies can bring stability of cash flows which in turn reduces the risk of insolvency and enhances the capacity of the new entity to service a larger amount of debt.
• By lowering the financial costs. This is because due to financial stability, the merged firm is able to borrow at a lower rate of interest. Limiting the severity of competition by increasing the company's market power. A merger can increase the market share of the merged firm. This improves the profitability and overall bargaining power. A merged firm can exploit technological breakthroughs against obsolescence and price wars.

• Taxes: A profitable can buy a loss maker to use the target's tax right off i.e. wherein a sick company is bought by giants.
• Geographical or other diversification: This is designed to smoothen the earning results of a company, which over the long term smoothens the stock price of the company giving conservative investors more confidence in investing in the company
• Resource transfer: Resources are unevenly distributed across firms and interaction of target and acquiring firm resources can create value through either overcoming information asymmetry or by combining scarce resources. Eg: Laying off employees, reducing taxes etc.
• Improved market reach and industry visibility: Companies buy companies to reach new markets and grow revenues and earnings. A merger may expand two companies' marketing and distribution, giving them new sales opportunities and also investment opportunities.

Divestment as an Exit Option The three most important steps involved in the analysis of an exit option for a company are:

• Planning: This will require the analysis of industry-specific and firm-specific information. The divesting firm should review its objective in the context of its strengths and weaknesses and corporate goals. This will help in indicating the product-market strategies that are appropriate for the company and in identifying the business units that should be dropped or added. On the other hand, the target firm will need information about quality of management, market share and size, capital structure, profitability, production and marketing capabilities, etc.
• Search and Screening: Search focuses on how and where to look for suitable candidates for acquisition or divestments. Screening process short-lists a few candidates from many available and obtains detailed information about each of them.
• Financial Evaluation: It is needed to determine the earnings and cash flows, areas of risk, the maximum price payable to the target company and the best way to finance the merger. In a competitive market situation, the current market value is the correct and fair value of the share of the target firm. The target firm may, in fact, expect the offer price to be more than the current market value of its share since it may expect that merger benefits will accrue to the acquiring firm. A merger/divestment is said to be at a premium when the offer price is higher than the target firm's pre-merger market value. The acquiring firm may have to pay premium as an incentive to target firm's shareholders to induce them to sell their shares so that it (acquiring firm) is able to obtain the control of the target firm.

Divestment to Promote Competition

The Indian legal regime addresses and regulates mergers, acquisitions, divestments and combinations. The basis of law related to mergers is codified in the Indian Companies Act, 1956 as amended which works in tandem with various regulatory policies. The general law relating to mergers, amalgamations and reconstruction is embodied in sections 391 to 396 of the Companies Act, 1956 but Section 394 deals with amalgamations specifically. In any scheme of amalgamation, both the amalgamating company or companies and the amalgamated company should comply with the requirements specified in sections 391 to 394 and submit details of all the formalities for consideration of the Tribunal.

It is not enough if one of the companies alone fulfils the necessary formalities. Before sanctioning the scheme of amalgamation, the Tribunal has to give notice of every application made to it under Section 391 to 394 to the central government and the Tribunal should take into consideration the representations, if any, made to it by the government before passing any order granting or rejecting the scheme of amalgamation. Thus, the central government is provided with an opportunity to have a say in the matter of amalgamations of companies before the scheme of amalgamation is approved or rejected by the Tribunal.

Under section 394, the Tribunal has been specifically empowered to make specific provisions in its order sanctioning an amalgamation for the transfer to the amalgamated company of the whole or any parts of the properties, liabilities, etc. of the amalgamated company. The assets and liabilities of the amalgamating company automatically get vested in the amalgamated company by virtue of the order of the Tribunal granting a scheme of amalgamation. The Tribunal also makes provisions for the means of payment to the shareholders. It is a concerning factor that powers still continue with the court for substantial part of things under the Companies Act, 1956 till the operationalization of the tribunal.

The Competition Act, 2002 The Act regulates the various forms of business combinations through Competition Commission of India. Under the Act, no person or enterprise shall enter into a combination, in the form of an acquisition, merger or amalgamation, which causes or is likely to cause an appreciable adverse effect on competition in the relevant market and such a combination shall be void. Enterprises intending to enter into a combination may give notice to the Commission, but this notification is voluntary. But, all combinations do not call for scrutiny unless the resulting combination exceeds the threshold limits in terms of assets or turnover as specified by the Competition Commission of India. The Commission, while regulating a 'combination', shall consider the following factors:-

• Actual and potential competition through imports;
• Extent of entry barriers into the market;
• Level of combination in the market;
• Degree of countervailing power in the market;
• Possibility of the combination to significantly and substantially increase prices or profits;
• Extent of effective competition likely to sustain in a market;
• Availability of substitutes before and after the combination;
• Market share of the parties to the combination individually and as a combination;
• Possibility of the combination to remove the vigorous and effective competitor or competition in the market;
• Nature and extent of vertical integration in the market;
• Nature and extent of innovation;
• Whether the benefits of the combinations outweigh the adverse impact of the combination. Thus, the Competition Act does not seek to eliminate combinations and only aims to eliminate its harmful effects.

The other regulations are provided in The Foreign Exchange Management Act, 1999 and the Income Tax Act, 1961. Besides, The Securities and Exchange Board of India (SEBI) has issued guidelines to regulate mergers and acquisitions. The SEBI (Substantial Acquisition of Shares and Take-overs) Regulations, 1997 and its subsequent amendments aim at making the take-over process transparent, and also protect the interests of minority shareholders.

With the FDI policies becoming more liberalized, activities around mergers, acquisitions and alliances are increasing in a big way. They are no more limited to a particular type of business. Indian markets have witnessed a growing trend in mergers, which may be due to business consolidation by large industrial houses, consolidation of business by multinationals operating in India, increasing competition against imports and acquisition activities. Therefore, the time is ripe for businesses and corporate houses to keep a close watch on the Indian market, and grab the opportunity.