DEMERGERS AND REVERSE MERGERS- AN

INSIGHTFUL STUDY
ARJUN.MAKUNY, III YEAR B.COM.LLB. (HONS), BC0140011.

TABLE OF CONTENTS

S.NO CONTENT PAGE NUMBER

1 Introduction 2
2 Birth of Demergers and 2
Reverse Mergers
3 Effect on Shareholders’ 5
Rights by way of Demergers
and Reverse Mergers
4 Liabilities of Shareholders in 9
Demergers and Reverse
Mergers
5 Conclusions and Suggestions 10
6 Bibliography 11

INTRODUCTION

1|Page
 DEMERGERS AND REVERSE MERGERS- AN
INSIGHTFUL STUDY
ARJUN.MAKUNY, III YEAR B.COM.LLB. (HONS), BC0140011.
Business or Corporate Restructuring is an integral part of the new economic paradigm which
paves way to competition and free trade, rationalization and reorganization. The rationale for
multitude of business combinations and permutations co-exists without any contradictions.
In the recent scenario, the business strategy which is invisibly gaining momentum in the
corporate world is “Demergers” and “Reverse Mergers”. The researcher through this small
piece of research critically aims to explore and analyse the emergence of Demergers and
Reverse Mergers in the new corporate scenario as a means of restructuring the business
model and the kind of repercussions it will have on the rights and liabilities of shareholders in
a Company by suggesting suitable alternatives to reduce the conflict of interest existing
between the Company and the shareholders.

BIRTH OF DEMERGERS AND REVERSE MERGERS

Any company’s primary motive is ‘Wealth Maximization’. Be it Demerger or Reverse

Merger, the desired end result is continuance of Synergy {enhanced cost efficiencies of the
new business}. The option of ‘Demerger’ comes to play only when the Company is not able
to perform well or is facing problems in managing its huge assets and hence the split happens
for effective functioning of the company. Reverse Merger enables a private company to
perform better through its capital reorganization. Thus, the sustainability of the company is
primarily maintained in both the cases. Hence, the company is always eager in reviving and
rejuvenating itself continually from its past annals of failed performance history. Demergers
are most commonly witnessed in Family run businesses wherein the healthy and robust
parent company is easily prone to division or split. Here, the performance of the company is
only a probability and can even boomerang affecting the credibility of the parent company.
In the case of a reverse merger, the cause behind performance index factor of the private
company which eventually turned public is ‘Synergy’ (especially negative Synergy) which
ensures that the prospects of the company are not at stake.

2|Page
 DEMERGERS AND REVERSE MERGERS- AN
INSIGHTFUL STUDY
ARJUN.MAKUNY, III YEAR B.COM.LLB. (HONS), BC0140011.
Simply, a Demerger allows a large company, such as a conglomerate, to split off its
various brands to invite or prevent an acquisition, to raise capital by selling off components
that are no longer part of the business's core product line, or to create separate legal entities to
handle different operations1. In other words, it involves the separation of a company's
business through the creation of one or more separate, publicly traded companies 2. It
generally takes place through a spin-off (a corporate restructuring in which one part of a
company is spun off as a new complete company often with a quoted status of its own) by
distributing or transferring the shares in a subsidiary holding the business to company
shareholders carrying out the demerger.

A Demerger can be full or partial and is usually carried out by distributing shares in the
business to be spun off, to shareholders of the company carrying out the demerger, in
proportion to their shareholding in the original company. When there is a partial demerger,
the parent company retains a stake, which is sometimes a majority stake in the demerged
business. For instance, in 2001, British Telecom conducted a demerger of its mobile phone
operations, BT Wireless, in an attempt to boost the performance of its stock. It took this
action because it was struggling under high debt levels from the wireless venture3.

Under the jurisprudence of Company Law, whenever a company opts for a demerger, the
immediate concern and effect would be the Shareholders since they form the crucial
component of any robust and successful business venture. Any action by the company
directed towards threatening the shareholders wealth or affecting the interests of shareholders
(be it both minority and majority) is practically not feasible. This very often results in conflict
of interests between the company and the Shareholders in a company.

In sharp contrast to a demerger, in a Reverse takeover or Reverse merger, shareholders of the

private company purchase control of the public shell company and then merge it with the \

1
Bryer, Lanning G., Cambridge University Press, Intellectual Property Assets in Mergers and Acquisitions, (2d
ed. 2002), pp.12.2-12.3
2
Ibid
3
Vroom De, Janssens Heraald, Frederikslust Van and Ruud A.I, “Shareholder Wealth Effects of Corporate
Spin- offs: The Worldwide Experience 1990-98”. Available at S SRN: http://ssrn.com/abstrac t=1738229 or
http://dx.doi.org/110.2139/ssrn.173829

3|Page
 DEMERGERS AND REVERSE MERGERS- AN
INSIGHTFUL STUDY
ARJUN.MAKUNY, III YEAR B.COM.LLB. (HONS), BC0140011.
private company4. The private company shareholders receive a substantial majority of the
shares of the public company and control of its Board of Directors5. Basically, the transaction
involves the private and shell company exchanging information on each other, negotiating the
merger terms, and signing a share exchange agreement. At the closing, the shell company
issues a substantial majority of its shares and Board control to the shareholders of the private
company. Here, even in the case of a public company which is not well-off, obviously the
private company shareholders have a substantial say in the merger dealings and other
negotiation agreements. Thus, in a way, the financial capability and strength of the shell
company is at the mercy of the private company when even the majority shareholders of the
shell company have a right to pass a resolution and question the modes of transaction of the
private company6. Thus, non-exercise of such right is indirectly affecting the shareholder’s
wealth procured in the shell company.

The private company's shareholders pay for the shell company by contributing their shares in
the private company to the shell company that they now control. This share exchange and
change of control completes the reverse takeover, transforming the formerly privately held
company into a publicly held company. In other words, the shell company’s rights of all
shareholders have been mutely taken over by the private company by prudential negotiations
and higher success rate of the private company. Moreover, a Reverse Merger only provides
the private company with more liquidity if there is a real market interest in it7.

Moreover, public trading includes the possibility of commanding a higher price for a later
offering of the company's securities 8. Going public through a reverse takeover allows a
privately held company to become publicly held at a lesser cost, and with less stock
dilution than through an initial public offering (IPO). In a reverse takeover, a company can go
public without raising additional capital which greatly simplifies the process. In addition, a
reverse takeover is less susceptible to market conditions9.

4
William K Sjostrom, The Truth about Reverse Mergers, 37 Entrepreneurial Business Law Journal, (1999), p.2
5
Ibid at p. 4
6
Avtar Singh, Eastern Book Company, Company Law (16th ed. 2015), pp. 285-286
7
S. Ramanujam, LexisNexis, Mergers et al, (3d ed. 2011), pp. 1210-1211
8
Ibid
9
Ibid

4|Page
 DEMERGERS AND REVERSE MERGERS- AN
INSIGHTFUL STUDY
ARJUN.MAKUNY, III YEAR B.COM.LLB. (HONS), BC0140011.
EFFECT ON SHAREHOLDER’S RIGHTS BY WAY OF DEMERGERS
AND REVERSE MERGERS

Present day de-mergers are creating enormous wealth for shareholders at the same time
affecting their credibility and rights as a whole 10. In this connection, several studies have
empirically analysed the shareholder’s rights around spin-off. The potential reasons of
shareholder rights from spin-offs analysed in these studies may be classified as follows:

1) Transfer of wealth from bondholders to shareholders in the company;

2) Tax and regulatory advantages;
3) Restructuring of Incentive Contracts;
4) Improved focus and elimination of negative synergies.

Among these, the improved focus and elimination of negative synergies through dynamic
exercise of shareholder’s rights hypothesis is an explanation that has received broad empirical
support. According to Thomas Kirchmaier, it is far from obvious how a simple break-up of
an organisation into smaller units would create value. The value of two business units should
be identical (parent and subsidiary) before and after a demerger, unless some positive or
negative synergies exist that create or destroy value under a combined ownership structure11.

Such grave threats can be aborted if shareholder’s in the company take an active interest by
exercising their rights to prevent the company from being gulped by the demerging process:
1. Passing of Resolution by majority shareholder’s against the demerger;
2. Ensuring the security of the shareholder’s wealth and share price in the subsidiary
company by the parent;
3. Retaining the essential rights and control by the parent company during a demerger;
4. Active Interaction between the shareholder’s and the company during managerial
decision making or Board meeting to protect the interests of the company.

Supra note 4
10

Dr. G.K. Kapoor & Sanjay Dhamija, Taxmann Publications Pvt. Ltd., Taxmann’s Company Law, (18th ed.
11

2015), p. 245

5|Page
 DEMERGERS AND REVERSE MERGERS- AN
INSIGHTFUL STUDY
ARJUN.MAKUNY, III YEAR B.COM.LLB. (HONS), BC0140011.
A demerger is therefore a sensible option if negative synergies or diseconomies of scale exist
that can be eliminated by separating the firm into two or more independent entities 12. The
controversial arena is the extent and the liberty under which shareholders can effectively
utilize their rights to prevent the company from going bust whenever the company in the
name of Corporate Restructuring opts for a Demerger.

Dissenting Shareholder’s Right of Withdrawal from Demergers: Article 131 of the

Consolidated Law on Financial Intermediation (Legislative Decree 58 of February 24 1998)
provides: "Shareholders not in agreement with resolutions approving mergers or demergers
that involve the allocation of unlisted shares may withdraw pursuant to Article 2437 of the
Civil Code". Article 131 is intended to protect minority shareholders once a corporation loses
its listed status. A dissenting shareholder is not considered to have reason to withdraw at the
time that the resolution to demerge is made; rather, the right to withdraw is not triggered until
the demerger deed has been executed and filed, and the allocation of unlisted shares resulting
from the transaction has taken place. Any holder of listed shares who receives non-listed
shares as a consequence of a demerger transaction is entitled to withdraw. Moreover, any
holder of non-listed financial instruments issued by a previously listed corporation may
exercise the right of withdrawal where the corporation is delisted following a demerger13.

In the event of a demerger transaction, the delisting may concern only some of the shares of
the demerged corporation. This occurs in any case of partial demerger resulting in the
nullification of a portion of the company's shares, but it may occur even in the case of a total
demerger, where some of the shares of the demerged corporation are exchanged for listed
shares of the beneficiary corporation, with the remaining shares exchanged for non-listed
shares14. Thus, the right of withdrawal may be exercised only for that portion of listed shares
in the demerged corporation which are exchanged for non-listed shares in the beneficiary
corporation, and not for those shares which remain listed. But shareholders do not have the

12
Ibid
13
Supra note 11, p. 247
14
Supra note 11, p. 248

6|Page
 DEMERGERS AND REVERSE MERGERS- AN
INSIGHTFUL STUDY
ARJUN.MAKUNY, III YEAR B.COM.LLB. (HONS), BC0140011.
right of withdrawal where the new company resulting from a demerger transaction lists its
shares at the time that the demerger becomes effective15.

In a demerger, the activities separated at the time of demerger are critical factors. The overall
size of the business entity and the extent of the profits that it makes is one important factor
that determines the pricing of the newly-listed shares. Also, the future potential will
determine the price impact after the demerger.

Hindrances in the Current Legal Provisions Relating to a Demerger: During the

demerger process, generally the parent company’s business is reduced to the minimum and
no significant assets are left from which the shareholders can retrieve their value of the share
price in case of a boomerang. Provisions 393A, 393B and other associated provisions under
the Companies Act, 2013 needs a fresh look. It is necessary to specifically lay down concrete
provisions so that demergers should not result in defeating the object of the Companies Act
and the vested interests of shareholders in a Company16.

Contrary to the above, owners of well developing and growing private companies are often
advised by financial advisors that they can go public without going through a complex and
extensive process and incurring the expenses of an IPO by using the so called “reverse shell
merger” technique17.

Capital Structure Issues: The first issue commonly encountered in a reverse takeover is that
the Public Shell might not have enough authorized shares of common stock to enable it to
issue 80%-85% of common shares to the shareholders of the Private Company. For instance,
the Public Shell might already have 50% of its authorized common shares issued to its
current shareholders18. This is a clear witness of conflict of interests between the shareholders
of a private company and the shareholders of a shell company. How far has the Companies
Act equipped itself in dealing with such controversial anomalies and conflicting situations?

Pursuant to Section 242 of the Delaware General Corporation Law (“DGCL”), each of these
alternatives requires an amendment to the ‘Certificate of Incorporation’ (CoI) of the Public

15
Supra note 6, pp. 301-302
16
Gower and Davies, Sweet and Maxwell Publications, Company Law, (9th ed. 2014), p. 302
17
Ibid, p. 307
18
Supra note 7, pp. 1216-1217

7|Page
 DEMERGERS AND REVERSE MERGERS- AN
INSIGHTFUL STUDY
ARJUN.MAKUNY, III YEAR B.COM.LLB. (HONS), BC0140011.
Shell. Pursuant to the same provision, shareholder approval is necessary to amend the CoI.
Whether such shareholder approval can be obtained by written consent of the majority
shareholder(s) depends on the applicable corporate statute and the Public Shell’s by-laws.
For instance, under DGCL, majority shareholder consent is possible unless the by-laws state
otherwise; under Section 615 of the New York Business Corporation Law, generally
unanimous shareholder consent is required, unless the CoI provides otherwise. Depending on
the outcome of the analysis of the applicable corporate law, the CoI, and the by-laws, a
shareholders meeting might be required prior to closing. However, both a shareholders’
meeting and a majority shareholder written consent will trigger time consuming procedures
mandated by federal securities laws as set forth in Section III which will delay a closing
substantially19.

In a Reverse Shell Merger, the shareholders of the private company are acquiring the public
shell and are granting a certain percentage of the merged entity to the Public Shell
shareholders in consideration therefor. It is a clear indication that the private company always
has an upper hand over the affairs of the shell company and subservient position of the shell
company starts at an early stage itself20. Keeping in mind that the public shell practically has
no assets, the private company shareholders are giving up a share in the merged entity in
exchange for the privilege of becoming a reporting company. Since no actual value is given
by the public shell or its shareholders, it is particularly important to ensure that no hidden
liabilities exist that will diminish the value of the ongoing entity in the future. There is no one
who can be held liable by the shareholders of the private company, which now owns a
majority (usually around 80% to 85%) of the merged entity. Shareholders and management of
the public shell are in most cases not willing to stand personally behind any representations
or warranties given by the public shell in the merger agreement. Therefore, any due diligence
of the public shell must focus on the possibility of hidden liabilities or other impediments to
the transaction21.

Going public is not an end in itself but a means to an end. Reverse takeovers always come
with some history of diverse shareholders. Additionally, these shells may sometimes come

19
Supra note 6, p. 198
20
Ibid
21
Supra note 16, p. 311

8|Page
 DEMERGERS AND REVERSE MERGERS- AN
INSIGHTFUL STUDY
ARJUN.MAKUNY, III YEAR B.COM.LLB. (HONS), BC0140011.
with angry or deceitful shareholders who are anxious to "dump" their stock at the first chance
they get. The acquiring or surviving company can safeguard against the "dump" after the
takeover is consummated is by requiring a lockup on the shares owned by the group from
which they are purchasing the public shell. Other shareholders that have held stock as
investors in the company being acquired pose no threat in a dump scenario because the
number of shares they hold is not significant22.

LIABILITIES OF SHAREHOLDERS IN DEMERGERS AND REVERDE

MERGERS

Shareholders (majority and minority) of usually big companies are imposed with many duties
and liabilities under the Companies Act, 2013. The pure action of duties and liabilities
imposed upon them are not effectively exercised by them because of the kind of position they
stand with the company. Say for instance, a majority shareholder who has got substantial
amount of shares in a publicly traded company and if all of a sudden, the company goes into
liquidation, the member is liable towards the assets of the company as he is a member of the
company. Since they are bound to the company by all the covenants of articles of association,
it is obvious that the burden will be more on them as the company may have lien on any
amount due from them to the company.

No shareholder or member wants to be voluntarily burdened towards the asset liabilities of

the company. Even in demergers and revere mergers, when shareholders exercise completer
rights and control in determining the option for a demerger and reverse merger, why isn’t that
the rights conferred upon them are not effectively exercised for the benefit and sustenance of
the company? Can wealth maximization override the reputation and credibility of the
company? Is so, at what cost? Shareholders liabilities in case of demerger and reverse
mergers come to the fore when the prospects of the company are dim and the company is
financially weakened which may enter the process of liquidation very soon. It has a

See Krishnaswami S. and V. Subramaniam, “Information Asymmetry, Valuation & The Corporate Spin-Off
22

Decision”, Prentice hall of India, 1999.

9|Page
 DEMERGERS AND REVERSE MERGERS- AN
INSIGHTFUL STUDY
ARJUN.MAKUNY, III YEAR B.COM.LLB. (HONS), BC0140011.
prospective consequence for a retrospective action23. The conflict of interests exists between
shareholders to derive maximum benefit out of the company and the company to ensure that
its profit keeps escalating so as to benefit the company on the whole. Liability of both the
shareholders and the company are to be equivocally and harmoniously balanced to ensure
that the company is prospering and successful.

CONCLUSION AND SUGGESTIONS

Profit is a basic need for any organization to survive and future growth but it should not be
the sole objective of any Company. As in a corporate organization; shareholders, who are the
real owners of the company, are different from management, so every Company should
equally try maximizing and securing their wealth through active participation with
shareholders by steadily increasing their efficiency at the same time. Since market price of a
share also acts as a barometer of the company‘s performance, it is in the best interest of both
the management and the shareholders to reduce their conflict and work effectively by
simultaneously enhancing and maintaining their harmonious interests.

23
Supra note 7, p. 316

10 | P a g e
 DEMERGERS AND REVERSE MERGERS- AN
INSIGHTFUL STUDY
ARJUN.MAKUNY, III YEAR B.COM.LLB. (HONS), BC0140011.
BIBLIOGRAPHY

List of Books Referred:

1. Dr. G.K. Kapoor & Sanjay Dhamija, Taxmann Publications (P.) Ltd, Taxmann’s
Company Law, (18th ed. 2015).
2. Gower and Davies, Sweet and Maxwell Publications, Company Law, (9th ed. 2014).
3. S. Ramanujam, LexisNexis, Mergers et al, (3d ed. 2011).

List of Journals Referred:

1. Krishnaswami S. and V. Subramaniam, “Information Asymmetry, Valuation & The

Corporate Spin-Off Decision”, Prentice hall of India, 1999.
2. Thomas K, “The Performance Effects of European Demergers”, Working Paper,
Centre for Economic Performance, 2003.
3. Nag G.C. & Pathak, “Corporate Restructuring: A Boon for Competitive Advantage”,
Advances in Competitiveness Research, Vol. 17, 2008.
4. Vroom De, Janssens Heraald, Frederikslust Van, and Ruud A.I., (1999), “Shareholder
Wealth Effects of Corporate Spin-offs: The Worldwide Experience 1990-98,”
Available at SSRN: http://ssrn.com/abstract=1738229 or
http://dx.doi.org/110.2139/ssrn.173829.

List of Websites Referred:

1. http://www.capitalmarket.com/cmedit/story11-43.asp? SNo=175119‖, Investment

Strategy (last visited on 25-4-2017 at 05:30 P.M. {IST}).
2. http://www.thehindubusinessline.com/mentor/2007/06/04/stories/2007060400261200.
htm, (last visited on 23-04-2016 at 11:25 P.M. {IST}).
3. http://www.thefreelibrary.com/Untying+the+knot:+planning+for+demerger:+a+well-
drafted+agreement...-a0170815233 (last visited on 28-04-2017 {N.T.M.}).

11 | P a g e