This article is written by Nishish Mishra Rajnish, pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.

Introduction

Stock splits (also known as sub-division of shares) and reverse stock splits (also known as consolidation) of shares are the methods of alteration of the share capital of a company. Any variation in the share capital always requires compliance under the Companies Act, 2013 as well as compliance with the constitutional documents of the company.

Section 61 of the Companies Act, 2013 deals with such alterations.

In this article, we will be critically examining what stock splits are, followed by the reason a company chooses to split its stock and how the splitting of share certificates take place. We will also try to understand what is a reverse stock split and whether or not a shareholder’s approval is required for such a split.

What is a stock split?

A stock split or subdivision is the division of existing shares into many shares. The number of shares in the company will eventually increase after the shares are split. A share split is always considered with reference to the face value of the shares and not the market value.  For example, a share of the face value of Rs.10 will be split into two shares of face value Rs.5 each. Here, the market value of the shares will not be a reference point since it is dynamic in the case of a listed company and is based on the net assets in the case of an unlisted company.

After the share split, both the face value and the market price of the shares will be reduced as the number of outstanding shares is increased. Although a decrease in the face value or an increase in the outstanding shares never harms the market capitalization of the company, the decrease in the market price can certainly increase the trading and consequently result in an increase in the market price.

Why would a company want to split its shares?

1. Unaffordable shares

The purpose of a share split is to make the shares more affordable to retail investors. High-priced shares are usually traded by high net worth investors and institutions. In this case, the trade volume of the shares is less since the shares are restrictively traded by a particular class of investors. 

2. Psychological effect

Splitting of shares makes the investor feel that they hold more shares, which results in building confidence among the existing shareholders. Further, the low price is perceived to be less risky and this increases the demand for the shares.

3. Competitiveness

Occasionally, the organization also uses this strategy as a tool to increase the price of the shares in comparison to its competitors. As the perception among the shareholders regarding the positive growth of the company increases, the demand for the shares also increases.

Splitting of share certificates

Share certificates are now relevant only for private companies, but these companies are most preferred by entrepreneurs, at least in the early stages of the business. Further, as we saw above, splitting of shares happens largely in the case of companies who want to increase the trading in shares by splitting the same and thus making the market price more affordable.

However, splitting of share certificates happens when a certificate bearing a large number of shares is split into two, to facilitate the transfer of a smaller number of shares. Where there are physical share certificates in place, splitting of shares definitely results in the splitting of share certificates because the certificate will now contain double the number of shares. However, the splitting of share certificates is not necessarily a consequence of the splitting of shares.

The provisions of Section 46 read with Rule 6 of the Companies (Share Capital and Debentures) Rules, 2014 deals with the provision with respect to the issue of renewed or duplicate share certificates. In the case where a renewed certificate is issued in subdivision or consolidation of shares, the renewed share certificate shall be issued subject to the condition of surrendering the original share certificate.

What is a reverse stock split or consolidation of shares?

A share consolidation is the opposite of a share split and hence, it is also called a reverse stock split. A share consolidation is the merger of a set of existing shares into one share. Unlike share split, the shareholder’s rights like the right to dividend or voting rights in case of consolidation remain intact. However, as the share base decreases, it increases the share price.

For example, let’s say you own 100 shares in ABC Inc, and they are trading at 2 INR per share each. So, your total shares are worth 200 INR (100 x 2 each). If ABC Inc decides to do a 1:2 reverse split, that means you will now own 50 shares, trading at 4 INR each. Your investment is still worth 200 INR, but the stock’s price is double what it was. Earnings per share are also now doubled. That sounds good, right?

A reverse stock split has no inherent effect on the company’s value, with its total market capitalization staying the same after it’s executed. Yes, the company has fewer outstanding shares, but the share price increases in direct proportion to the reverse stock split.

Reverse stock splits aren’t without flaws. In many cases, companies keen to artificially boost their share price in this manner risk being spurned by investors.

Reverse stock splits can carry a negative connotation. As previously stated, a company is more likely to undergo a reverse stock split if its share price has fallen so low that it is in danger of being delisted. Consequently, investors might believe the company is struggling and view the reverse split as nothing more than an accounting gimmick.

When does a company consolidate its shares? 

1. To deal with the bearish investor sentiment

The consolidation of shares is processed when the price of the shares falls lower than expected and hence, becomes unattractive to investors. Poor performance and consistent bearish trends can result in removal from market indexes (if the regulations of the respective stock exchange provide so). By consolidation, the price of shares jumps to a higher level and thus improves the investor sentiment for the company and again, may result in increasing the trading in the company.

2. To reduce outstanding shares

By adopting the method of consolidation, the companies decrease the number of outstanding shares. As the number of outstanding shares falls there may also be a smaller number of shareholders which the company now needs to service.

3. To improve the company’s image in the market

A share with a single-digit is termed as “penny stock”. An increase in the price of shares with the help of consolidation will also enable the company to regain its reputation in the market.

4. To attract investors

Consolidation is also conducted to gain more attention from analysts and investors. As the price increases, it becomes an attractive topic for investors to look upon.

Consolidation is merely an artificial increase in the price without redressing the factors which resulted in the price sinking in the first place. Consolidation may, therefore, backfire and not result in an increase in trading of the shares of the company as may have been expected.

Is shareholder approval required for stock splits and reverse stock splits?

Interestingly, Section 61 of the Companies Act, 2013, which deals with the alteration of the share capital of the company states that “A limited company having a share capital may alter its memorandum in its general meeting…….”, thereby mandating a resolution from the shareholders at a general meeting. However, Section 13, which deals with the alteration of the memorandum, makes an exception of Section 61, while requiring a special resolution to alter the provisions of the memorandum. A combined reading of these sections will mean that the alteration to capital can be approved by an ordinary resolution of the shareholders.

This, however, is subject to the condition that the Articles of Association does not contain the details of the capital and simply states that the capital shall be as per a specific clause of the memorandum. If the articles are required to be altered in any manner, a special resolution will be required. Further, if the articles make it mandatory to secure a special resolution for altering capital, even then the special resolution will be required although this is not mandatory under the Companies Act, 2013.

Conclusion

Stock split and reverse stock split of shares are the methods of alteration of the share capital of a company which are briefly covered in Section 61 of the Companies Act 2013. The mechanism of reverse stock split helps a company recover from losses and avoid the adverse results of delisting. In the past, several stocks have shown an uptick in price after this exercise. In the short term, it can increase the price of a share.

For the investor, a reverse stock split allows trading with better liquidity. The psychological value of shares goes up after this exercise with a higher value. 

References

• http://ebook.mca.gov.in/default.aspx 
• https://www.investopedia.com/ask/answers/what-stock-split-why-do-stocks-split/ 
• https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/reverse-stock-split/

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