In this article, Aastha Jain discusses demergers under the Companies Act.

You must be familiar with the famous demerger of Max India Limited which was announced in 2016. Max India Limited which is regarded as one of India’s leading business corporates announced its demerger into three listed companies- Max Financial Services Ltd., Max India Ltd., and Max-Ventures & Industries Ltd. The reason for this demerger was to boost their growth and development phase and also enable them to have a sharper focus on each of the operating businesses. Demerger maybe due to many other reasons as well. For better understanding, we will discuss the aspects of demerger in detail

Meaning of demerger

A demerger can be regarded as a business strategy where one company transfers one or more of its business undertakings to another company. In other words, it can be considered as a type of corporate restructuring in which a business is broken into components, either to operate on its own, to be sold or to be liquidated.

Types of demerger

A demerger can take place in two forms. They are:

• Spin-off: this is a kind of divestiture strategy where the company’s division or undertaking is separated from the parent company. Once they are spun- off, both the parent company and the resulting company act as separate corporate entities. It can be regarded as a creation of an independent company through the sale and distribution of new shares of a business which is already existing or can be a division of a parent company.

The reason behind this type of divestiture is to attract more outside investments which can be done when the business unit is operating under independent management. It is expected that after the spin- off the companies will be worth more as independent entities than as parts of a larger business. This strategy is also adopted when the company wants to dispose of the non- core assets.

• Split up: this is a type of business strategy when a company splits up into one or more independent companies by which the parent company ceases to exist. Once the company is split into different entities, the shares held by the parent company are exchanged for the shares in the new company formed. These shares are distributed in the same proportion as they are held by the original company, depending on the situation.

The reason for adopting this business strategy would be if the government mandates it in order to curb the monopoly practices or if the company has several business lines and the management is unable to control all of them at the same time, they may separate it to be able to focus on the core business activity.

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Reasons for Demerger of companies

There are many reasons for a company to undergo the demerger process. Some of them are:

• Dismantling of conglomerates

Historically, demergers were used as a tool to dismantle conglomerates as running such organizational structures was a hefty task and proved that the cost outweighed the benefits reaped in the economic environment. Dismantling conglomerates was based on the idea to eliminate the inefficient organizational structures and reducing the negative synergies.

• Compliance with rules and regulations

The action may be necessary in order to comply with the rules and regulations of the local territory in which the company wishes to establish. If the regulations laid down by the authority state that the company needs to emerge before establishing itself in the country then the company has to emerge in order to operate in that country.

• Focus on core business

Companies which own more than one business and the smaller one is not recognized in the valuations of these companies the demerger maybe a way to separate these investments out of the core business. This way more focus and resources will be diverted to the core business and productivity can be increased. With the help of demerger, companies can become more flexible and venture into other growth opportunities.

• Attract investors

A demerger generates cash which can be used by the parent company to pay off its debt. This way a demerger can save a lot of interest on debt and also increase the cash flow to the equity holders. The prospect of receiving a higher dividend increases the share price of the parent company. Demerger attracts new investors which have an interest in particular sectors.

Example: Pantaloon which is a retail brand was only attracting retail investors, by spinning off a private equity fund, Kshitij it attracted investors of a different sector.

• A tool for value creation for shareholders

It is true that with the help of demerger, the company is able to focus on its core goal of each business which can be reflected in the increasing valuation of the company in the market.

Example: Dabur India demerger which comprised of the FMCG business included personal care, ayurvedic and healthcare products. They have a pharmaceutical wing which includes allopathic, oncology and other drugs. The main reason for this demerger was to establish a global presence in the pharmaceutical industry.

• Ability to leverage on an equity account

Companies when in a high growth phase need funding on an ongoing basis in order to expand their capacity and establish a global presence. There is a limitation on raising debt and also internal accruals for the company which can cause hindrance for expansions plans. Here demerger offers a solution as the company here can choose to dilute equity in only a particular business.

Demergers in the Indian legislature

The term demerger is not defined in the companies act, 2013. However, an explanation is given to section 230(1) of the said act prescribes it as an arrangement for the reorganization of the company’s share capital by:

1. Consolidation of shares of different classes
2. Division of shares of different classes
3. Or both.

Demerger is defined under Section 2(19AA) of the Income-Tax Act, 1961 in relation to companies can be defined as a transfer pursuant to the scheme of arrangement under sections 391-394 of the companies act 1956(old act) by a demerged company of its one or more undertakings to any resulting company in a manner by which:

• All the property of the undertaking, being transferred by the demerged company, immediately before the demerger, becomes the property of the resulting company by virtue of the demerger
• All the liabilities relatable to the undertaking, being transferred by the demerged company, immediately before the demerger, become the liabilities of the resulting company by virtue of the demerger
• The property and the liabilities of the undertaking or undertakings being transferred by the demerged company are transferred at values appearing in its books of account immediately before the demerger
• The resulting company issues, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis except where the resulting company itself is a shareholder of the demerged company
• The shareholders holding not less than three-fourths in value of the shares in the demerged company (other than shares already held therein immediately before the demerger, or by a nominee for, the resulting company or, its subsidiary) become shareholders of the resulting company or companies by virtue of the demerger, otherwise than as a result of the acquisition of the property or assets of the demerged company or any undertaking thereof by the resulting company
• The transfer of the undertaking is on a going concern basis
• The demerger is in accordance with the conditions, if any, notified under Income-Tax Act, 1961, s 72A(5) by the central government in this behalf.

Process of demerger

The process of demerger under the Companies Act, 2013 is as follows

Preparation of scheme of demerger

This is the most important step in the process of demerger as the scheme of arrangement is the most vital document as by this document the company binds all related stakeholders to the demerger of the company. It would deal with the details of the transfer of employees, payment to creditors, transfer of debt, assets, liabilities etc. it can be proposed by the directors or the liquidator of the company. The scheme of arrangement has to be accepted by the shareholders, employees, creditors, and stakeholders.

Application in court

For the demerger process to commence an application has to be filled in form 33 along with the affidavits of the promoters to the High court. The documents required are:

• Memorandum and Articles of Association of the Company
• Audited Balance Sheets (recent)
• List of Shareholders and Creditors
• Extract of Board Resolution approving the Scheme of arrangement
• Scheme of Arrangement
• Draft notice of Meeting, Explanatory Statements, and replacement

• Issue of Notice

A notice has to be issued to all the interested parties, 21 days prior to the meeting and this notice has to be published in form 38 through newspapers.

Holding of meeting

A meeting has to be held in accordance with the rules of the court and has to be recorded.  A report in form 39 has to be submitted by the chairperson of the meeting.

Petition and sanction by the court

This is the final step of the process by which a petition has to be filed in the court which has to be sanctioned by three-fourths of members/creditors to file an appeal. The court will pass an order after hearing the objections. The court will then pass an order approving the demerger in the same newspaper where the notice was advertised.  

Understanding Demergers with examples

The most common example would be of Reliance Industries Ltd which had unanimously approved the scheme of demerger of the business of the company in August 2005. The committee along with the advisors presented a scheme of demerger with the objective of unlocking the value of all shareholders, the board of directors and to examine in depth all the issues including statutory and legal requirements for the reorganization. The scheme of demerger was approved by the board, Mumbai high court, stock exchanges, and shareholders

Scheme of demerger

The scheme had proposed to demerge assets and liabilities into the following undertakings:

1.    Telecommunications undertaking
2.    Coal-based energy undertaking
3.    Financial services undertaking
4.    Gas based energy undertaking

Benefits to shareholders

From the demerger of Reliance Industries the shareholders would be benefited in the following ways:

• The shareholders of the company participated in the growth and progress of the company by holding the same shares in the global oil, gas, refining and Petrochemicals Company as they held in the current company
• They would also receive separate shares in the demerged entities, which would allow them to participate separately as well as collectively in the growth areas of the demerged entities.
• Also, the shares of the resulting companies will be listed on the stock exchanges where the shares of the company are currently listed which will provide liquidity to all shareholders.
• The shareholders can participate directly in all the businesses which will unlock value and provide growth aspects.

Another recent example of demerger would be of Wipro which declared its scheme of demerger would be effective from 31st March 2013.

Wipro declared to demerge its non-IT business into a separate unlisted company called Wipro Enterprises. The reason for this demerger was aimed at creating a separate company out of Wipro’s customer care, lighting, furniture, hydraulics, water, and medical diagnostic product business. By separating the entities Wipro can focus exclusively on its IT sector. The resulting company is a private limited company which does not have any shares listed on the stock exchange.

The 3 units which have demerged into one separate entity provided for 14 percent of the total revenue for the company whereas the IT business contributed to the rest 86 percent. By this demerger, Wipro would be able to focus more on the IT business and accelerate revenue.

Conclusion

A Demerger is an approach adopted by companies to boost their shareholders value in the long run but it must carve out the objective and clear perspective of the businesses which are to be operated separately. the objective of the demergers should be very clear and implementation should be done keeping the benefits of all the stakeholders in mind. Demergers have proved to be a huge success in many companies when implemented with extensive planning.