Demystifying Demerger: A Tool For Corporate Restructuring

What Is Demerger?

Demerger is a corporate restructuring process in which a business is divided into components which either operate as a separate unit or can be liquidated. It allows a company to split or divide itself into various units. Demerger of a company involves division or split of a company into various small companies, these new companies are not necessarily subsidiaries of the parent company after the split. In a demerger, the parent company transfers the assets, liabilities, and operations of the identified business units to separate entities, which then operate autonomously.

It is an effective and efficient course of action for the companies which want to reduce the risk of operating as a large unit and can separate out the underperforming units. Where a company performs various operation and activities demerger allows them to focus on their core and profitable operations.

Why Do Companies Opt For Demerger?

A company opts for demerger for several strategic reasons which also takes into account the financial and legal position of the company.

• Operational Efficiency- A company which operates as a large unit can demerge itself into specific units which have greater flexibility to adapt to market changes, implement targeted strategies, and make decisions without being restricted by a broader corporate structure.
• Focus on Core Business-One of the primary reasons for a demerger is to allow a company to concentrate on its core business activities. By divesting non-core or unrelated business units, a company can streamline its operations and allocate resources more efficiently, enhancing its focus on the areas where it has a competitive advantage.
• Risk Reduction – Demerger reduces financial risks for the companies which operates at a large scale in diverse industries and only few units are efficient and profitable. In such cases company can split itself and only operate those units which have operational efficiency and are profitable . This reduces the financial constraints faced by the company.
• Strategic Repositioning – Changes in the business environment, industry dynamics, or regulatory conditions may prompt a company to re-evaluate its strategic positioning. A demerger can act as a proactive response to align the business with evolving market trends and demands.
• Financial Restructuring – Demergers can be a part of a financial restructuring plan of a company. Companies may seek to optimize their capital structure, reduce debt, or improve financial ratios by divesting certain business units

Types Of Demergers

1. Spin off – This demerger involves creating of a subsidiary firm by distributing shares of the parent companies to existing shareholders in the form of special dividends. The shareholders of the parent company typically receive shares in the spun-off entity in proportion to their existing holdings in the parent company. This type of demerger allows the subsidiary company to decide and carry out its own strategies.
2. Split off – In this type of demerger the shareholders are offered shares in the subsidiary companies but they have two option that they can either continue to hold shares in the parent company or else they can exchange the shares held with them in parent company for shares in subsidiary company.
3. Equity Carve-out – In this demerger the parent company sells some or all of the shares in its subsidiary company to the public through an initial public offering (IPO).The subsidiary becomes a publicly traded company, and the parent company usually retains a significant ownership stake.
4. Split up – In a split-up, the parent company divides its operation by splitting into a single holding company and its various subsidiary companies, each focusing on a specific business line. Shareholders receive shares in the new companies based on their holdings in the original company.Financial assets are with the holding company and it doesn’t operate physically. It only has the holdings of all the shares of its subsidiaries.
5. Divestiture – Divestiture involves selling a business unit or division to another company, either through a sale of assets or shares. The parent company receives cash or equity in exchange for the divested business, and the acquiring company takes control of the divested operations.

Process Of Demerger

1.Preparation Of Scheme Of Arrangement

This one of the most essential part of the demerger process. Scheme of arrangement is a document which binds all the stakeholders on similar terms. It includes information such as the transfer of employees, share exchange ratio, the transfer of debt, assets and liabilities. After acceptance of such arrangement a board resolution shall be passed which shall approve the prepared arrangement scheme.

2.Application In Tribunal

After the scheme of arrangement is approved an application shall be made to the tribunal under Form no. NCLT-1to order a meeting of creditors and members  which shall also include an affidavit under Form No. NCLT-6it shall disclose thelatest auditors reports, latest financial position, reduction of share capital if any.

The tribunal may order the meeting of creditors or members and companies are required to circulate the following:

(i)   Draft of proposed scheme drawn up and adopted

(ii)  Confirmation that copy of scheme is filed with registrar

(iii) Report explaining effect of compromise,

(iv) Report of expert regarding the valuation

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3.Issue Of Notice

Notice of such meeting under Form No. CAA.2 shall be sent to all creditors, members individually at the address registered with the details of the compromise or arrangement and copy of valuation report. Such notice and other documents shall also be placed on website of the company. And in case of listed company such documents shall be sent to SEBI and stock exchanges and shall also be published in newspaper.

The Notice shall also provide that a person can vote in meeting themself or through proxies or by postal ballot within one month from the date of receipt of notice.

The Notice shall be sent to the statutory authorities mentioned (Reserve Bank of India, Central Government, Income Tax Authorities, Securities and exchange board of India, the registrar) in Form No. CAA.3 and if any representation is required to be made by them it shall be made within 30 days form the date of receipt of notice.

4.Holding Of Meeting And Submission Of Report

A meeting shall be held with all the members and creditors and the result of this meeting shall be recorded and also the votes in favour and against the motion.Result of the meeting to be decided by voting and the report of the result of the meeting shall be in Form No. CAA. 4. The result of meeting shall be submitted in Form No. CAA. 4  to the tribunal by the chairperson of the meeting within the time specified and if no time is specified within 3 days form the conclusion of meeting.

5.PETITION TO TRIBUNAL FOR CONFIRMING COMPROMISE OR ARRANGEMENT

When the proposed compromise or arrangement is agreed to by the members or creditors

the company (or its liquidator), shall, within seven days of the filing of the report by the Chairperson, present a petition to the Tribunal in Form No. CAA.5 for sanction of the scheme of compromise or arrangement.

6.ORDER BY TRIBUNAL

If the tribunal is satisfied it may by order sanction the compromise or arrangement the order shall be in Form No. CAA. 7. Copy oforder of tribunal to be filed with the Registrar of Companies within thirty days from the date of the receipt of copy of the order.

Challenges In The Process Of Demerger

• The process of separating business units can be complex and costly. There are expenses associated with legal, financial, and operational aspects, including the need for new management teams, systems, and infrastructure.
• Demergers can have tax implications for both the parent company and the newly formed entity. It’s important to carefully consider the tax consequences and plan accordingly to minimize any adverse effects. It is essential for the company to comply with tax laws and regulations.
• During the process of demerger if the IP assets are not protected it could create legal and financial challenge for both the parent and the new company. During demerger there shall be proper identification and valuation of the IP assets.
• Contractual disputes is also a challenge faced during the demerger process because when a company splits itself contracts are transferred to the new companies which give rise to dispute over which entity has obligation to fulfil the terms of the contract.

Author: Manit Sharma, in case of any queries please contact/write back to us at support@ipandlegalfilings.com or IP & Legal Filing