Preliminary and Incomplete: Do not cite
The Case Against Share Repurchases
Jesse M. Fried
Boalt Hall School of Law, U.C. Berkeley
Abstract
Public companies in the U.S. are increasingly using open market repurchases, rather
than dividends, to distribute cash. Two important reasons for this trend have been
identified: (1) the tax system implicitly subsidizes repurchases by taxing dividends more
heavily; and (2) the structure of managers’ options, which reflects financial accounting
considerations, gives managers a personal financial incentive to distribute cash through
repurchases rather than through dividends. However, the overall desirability of this trend
from an efficiency perspective has yet to be carefully examined. This paper systematically
analyzes the economic differences between repurchases and dividends, and concludes that
repurchases are likely to be a less socially desirable means of distributing cash than
dividends. The paper also proposes a new approach to the regulation of repurchases:
requiring firms buying back their stock on the public market to announce their repurchases
in advance. Such a disclosure rule would reduce the efficiency costs associated with the use
of repurchases without interfering with any of their benefits. The paper concludes by
examining the implications of its analysis for the current debates over the proper tax
treatment of dividends and financial accounting treatment of employee options.
JEL Classification: G30, G32, G35
Keywords: Payout policy, stock repurchases, dividends, signaling.
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Preliminary and Incomplete: Do not cite
TABLE OF CONTENTS
I. Introduction
II. Toward Reconsidering the Desirability of Repurchases
A. The Use and Regulation of Share Repurchases
B. Tax and Options - Accounting Explanations for Repurchases
1. The Implicit Tax Subsidy for Repurchases
2. The Options Accounting Bias Toward Repurchases
III. Reconceiving a Repurchase as a Redistribution Coupled to a Dividend
A. The Reconceptualization
B. The Dividend Component of a Repurchase
1. Allocation of Capital
2. Alteration of Leverage
3. Net Dividend Effects of a Repurchase
C. The Redistributional Component of a Repurchase
IV. The Problems with Coupling a Redistribution to a Dividend
A .Managers’ Use of Repurchases to Enrich Themselves
B. Potential Distortions
1. Underinvestment
2. Cash-hoarding
3. Reduced Disclosure
V. Arguments for Repurchases
A. Financial Flexibility
B. Share Value Signaling
C. Transaction Cost Savings
D. Funding Stock Option Plans
VI. The Desirability of Repurchases When Stock Demand Curves Slope Downward
A. The Possibility of Downward Sloping Stock Demand Curves
B. Managers’ Use of Repurchases to Sell at a Higher Price
C. Potential Distortions
1. Underinvestment
2. Cash-hoarding
VII. Inferring the Desirability of Repurchases from the World Around Us
A. Is There Evidence in Favor of Repurchases?
1. Market Reaction to Repurchase Announcement
2. Failure of Corporate Charters to Prohibit Repurchases
B. The Continuing Use of Dividends
VIII. A New Approach to the Regulation of Repurchases
A. The Proposed Approach: Pre-Repurchase Disclosure
B. The Benefits of Pre-Repurchase Disclosure
C. The Costs of Pre-Repurchase Disclosure
D. Implications for Dividend Taxation and Option Accounting Rules
IX. Conclusion
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I. INTRODUCTION
Firms are increasingly using open market share repurchases rather
than dividends to distribute cash. Two important reasons for this trend have
been identified: (i) repurchases are not taxed as heavily as dividends; and (ii)
the design of managers’ options, which reflects accounting considerations,
leads managers to prefer repurchases over dividends. However, little
attention has been given to the question of whether this trend is desirable
from a social (efficiency) perspective. To answer that question, this paper
systematically compares the economic features of repurchases to those of
dividends. The paper shows that repurchases are likely to be a less efficient
mechanism than dividends for distributing cash. In particular, managers’
ability to use repurchases to redistribute value to themselves from public
shareholders is likely to distort managers’ payout, investment, and
disclosure decisions. The paper also shows that each of the efficiency
benefits commonly attributed to repurchases can be achieved by a simpler
and more efficient mechanism (or by a dividend itself). Although
repurchases are likely to be less efficient than dividends, the paper does not
advocate restricting their use. Instead, the paper puts forward a new
approach to regulating open market repurchases: requiring advance
disclosure of repurchases. The paper shows that such a disclosure rule
would reduce the costs associated with repurchases without interfering with
any of their benefits and thus make repurchase a more efficient payout
mechanism. The paper concludes by discussing the implications of its
analysis for the debate over the optimal taxation of dividends and the proper
accounting treatment of employee options. 1
Over the last 20 years, the use of share repurchases to distribute cash
has increased substantially in the U.S., increasing from $1.4 billion in 1980 to
over $200 billion in 1998.2 Almost all of this cash is distributed through open
1 This paper is part of a larger project of mine on share repurchases by public
firms. Earlier work has examined managers’ motives for using the two main types of
public share repurchases – open market repurchases and repurchase tender offers. See
Jesse M. Fried, Open Market Share Repurchases: Signaling or Managerial Opportunism?, 2
THEORETICAL INQUIRIES IN LAW 865 (2001) (examining whether managers use open
market repurchases to signal that the stock is underpriced and concluding that they do
not); Jesse M. Fried, Insider Signaling and Insider Trading with Repurchase Tender Offers, 67
U. CHI. L. REV. 421 (2000) (examining managers= motives in conducting repurchase
tender offers (ARTOs@) and showing that managers= behavior is consistent with the use
of RTOs for insider trading).
2 See Gustavo Grullon & David L. Ikenberry, What Do We Know About Stock
Repurchases?, 13 J. APPLIED CORP. FIN. 31, 33 (2000); Scott Weisbenner, Corporate Share
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market repurchases (AOMRs@), in which the corporation uses a broker to
buy its own stock on the market over an extended period of time.3
Because of their growing importance, share repurchases have
attracted considerable attention from legal commentators and financial
economists.4 Much of the literature has focused on explaining why
managers are increasingly using repurchases rather than dividends to
distribute cash. The main explanation for repurchases= growing popularity
at the expense of dividends is that repurchases receive more favorable tax
treatment at the shareholder level. Another widely-cited explanation is that
the structure of managers’ options, which reflects accounting considerations,
biases managers in favor of repurchases.
Although the literature has sought to identify reasons for the
increasing use of share repurchases, little attention has been paid to the
normative question that is the focus of this paper - whether the increasing
use of share repurchases is, on balance, efficient B that is, whether the use of
Repurchases in the 1990’s: What Role Do Stock Options Play? 1 (working paper, 2000).
More recently, as other countries have begun removing tax and regulatory impediments
to share repurchases, the use of buybacks outside the U.S. has also dramatically
increased. See, e.g., Peter Goldstein, European Concerns Start to Warm Up to Share
Buybacks: Firms Seek Outlets for Cash As Earnings Improve, Interests Rates Decline, Wall St.
J. Eur., June 23, 1998, at 17 (noting that announced European buyback plans increased to
$42.7 billion in 1997 from $14.2 billion in 1996, in response to current and anticipated
liberalizing of share repurchase laws).
3 See Grullon & Ikenberry, supra note, at 33-34. Most of the remaining repurchases
take the form of a repurchase tender offer (―RTO‖), in which the corporation makes a
time-limited offer to purchase a specified number of shares, usually at a premium over
the market price. See generally Jesse M. Fried, Insider Signaling and Insider Trading with
Repurchase Tender Offers, 67 U. Chi. L. Rev. 421 (2000).
4 See, e.g., F.H. Buckley, When the Medium is the Message: Corporate Buybacks as
Signals, 65 IND. L. J. 493, 539 (1990); Robert Comment and Gregg A. Jarrell, The Relative
Signalling Power of Dutch Auction and Fixed Price Self-Tender Offers and Open Market Share
Repurchases, 46 J. FIN. 1243 (1991); Jesse M. Fried, Open Market Share Repurchases:
Signaling or Managerial Opportunism?, 2 THEORETICAL INQUIRIES IN LAW 865 (2001); Jesse
M. Fried, Insider Signaling and Insider Trading with Repurchase Tender Offers, 67 U. CHI. L.
REV. 421 (2000); David Ikenberry, Josef Lakonishok, and Theo Vermaelen, Market
Underreaction to Open Market Share Repurchases, 39 J. FIN. ECON. 181 (1995); Robert M.
Lawless, Stephen P. Ferris, and Bryan Bacon, The Influence of Legal Liability on Corporate
Financial Signaling, 23 J. CORP. LAW 209 (1998); Erik Lie and John J. McConnell, [RA:
insert title] 49 J. FIN. ECON. 161 (1998); R. Richardson Pettit, Yulong Ma, and Jia He, Do
Corporate Managers Circumvent Insider Trading Regulations? The Case of Stock Repurchases,
7 REV. QUANTITATIVE FINANCE AND ACCOUNTING 81 (1996); Nikos Vafeas, Determinants
of the Choice between Alternative Share Repurchase Methods, 12 J. ACCOUNTING, AUDITING &
FINANCE 101 (1997); Theo Vermaelen, Common Stock Repurchases and Market Signalling, 9
J. FIN. ECON. 139 (1981).
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repurchases rather than dividends to distribute cash generates a larger social
pie.
To answer that question, this paper analyzes the inherent economic
differences between repurchases and dividends – that is, those differences
that would remain even if the tax treatment of the two distribution methods
were identical. The paper shows that a share repurchase is economically
identical to, and can be usefully reconceptualized as, a two-part transaction
involving the corporation and all of its shareholders. In the first part of this
hypothetical transaction, ―remaining shareholders‖ (those shareholders who
remain after the repurchase) buy the shares of ―selling shareholders‖ (those
shareholders who sell their shares back to the firm) at the repurchase price. 5
This part of the transaction redistributes value between selling and
remaining shareholders whenever the repurchase price differs from the
actual value of the stock. I call this part of the hypothetical transaction the
―redistributional component.‖ In the second part, the corporation issues a
dividend (to the remaining shareholders). I call this part the ―dividend
component.‖ The reconceptualization makes clear that a share repurchase is,
essentially, a redistribution (between selling and remaining shareholders)
coupled to a dividend. Thus, the economic desirability of using repurchases
rather than dividends to distribute cash turns largely on the economic
desirability of managers being able to couple a redistribution to a dividend.
The paper shows that managers’ ability to couple a redistribution to a
dividend is likely to lead to distortions in managers’ payout, investment, and
disclosure decisions. First, when the actual value of the stock exceeds its
price, managers seeking to profit from the redistributional component of a
repurchase may well have an incentive to repurchase shares with cash that
would be better invested in the firm’s projects (the ―underinvestment
distortion‖). From an efficiency perspective, it would be desirable for
managers to distribute cash if, and only if, the expected return from
additional investment in the firm’s projects is less than the expected return
available to shareholders from investments outside the firm. However, when
managers can use a repurchase to transfer value from selling shareholders,
they will have an incentive to distribute cash that could be more efficiently
invested in the firm whenever the value transferred from selling
shareholders exceeds the value foregone due to the firm’s inability to use
those funds to invest in its high-value projects.
The second distortion arising from managers’ ability to use
repurchases is that managers might have an incentive to inefficiently hoard
5 Of course, shareholders may sell some but not all of their shares during a
repurchase. For ease of exposition, however, I will assume throughout this paper that
the shareholders who sell stock back to the corporation dispose of all of their shares in
the transaction. This assumption does not affect any of the analysis.
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cash rather than distribute it because of the possibility of using the cash later
to transfer value from selling shareholders (the ―cash-hoarding distortion‖).
From an efficiency perspective, it would be desirable for managers to keep a
certain amount of cash on hand to cover unexpected costs or shortfalls in
revenue. However, to the extent managers expect to be able to use a
repurchase to transfer value from public shareholders they will have an
incentive to keep excess cash in the firm.
Third, managers whose firms repurchase shares will be less willing to
disclose information to the market. It is a familiar point in the insider trading
literature that managers who can engage in insider trading have an incentive
to delay disclosure of information in order to maximize their informational
advantage over public shareholders. This distortion, the paper shows, also
can arise when managers are able to use repurchases to transfer value from
public shareholders.
Because managers cannot use dividends to transfer value from
shareholders, the payout, investment, and disclosure distortions associated
with repurchases do not arise from the use of dividends to distribute the
firm’s cash. Share repurchases thus can impose costs that dividends cannot.
But can repurchases offer any unique benefits that cannot otherwise be
provided? If so, these potential benefits could outweigh the potential costs
associated with repurchases and thereby make repurchases a superior
mechanism for distributing cash. The answer, in short, is ―no.‖
The paper considers four economic benefits attributed to repurchases:
that they provide: (1) greater financial flexibility; (2) a mechanism for
credible share-value signaling; (3) a way to lower shareholder transaction
costs; and (4) shares to ―fund‖ employee and managerial option plans. The
paper addresses each of these benefits attributed to share repurchases and
shows that each benefit can be achieved either by a dividend or by another
mechanism that is simpler and more efficient than a repurchase.
The paper also considers the possibility that a repurchase might boost
the stock price through a ―price pressure‖ effect – that is, by removing shares
from the hands of its lowest-valuing shareholders. The paper explains that if
repurchases can be used to boost the stock price solely by changing the
identity of the marginal shareholder, managers will have an incentive to
repurchase shares shortly before selling their own, in order to sell at a higher
price. The use of repurchases for this purpose may, in turn, give rise to the
same under investment and cash-hoarding distortions that can arise when
managers are able to use repurchases to transfer value from selling
shareholders.
After describing the efficiency and distributional effects of
repurchases, the paper considers the markets positive reaction to repurchase
announcements and other empirical regularities to determine if they shed
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any light on their desirability vis-à-vis dividends. The paper first examines
what can be inferred from the fact that stock repurchase announcements
boost the stock price. The paper explains why a positive reaction to
repurchase announcements does not demonstrate that repurchases are
efficient, either ex post or ex ante. And even if repurchases were efficient,
the positive market reaction would not demonstrate that repurchases are a
more efficient distribution mechanism than dividends. The paper then
considers the possible argument that share repurchases are desirable because
corporate charters would otherwise prohibit them. The paper explains that
even if share repurchases were significantly less efficient than dividends, it
might well be in shareholders’ interest that managers distribute cash through
repurchases rather than dividends because of the tax advantage that
repurchases offer shareholders. Thus the failure of corporate charters to
prohibit repurchases cannot be interpreted to mean that share repurchases
are socially desirable. Finally, the paper argues that the continuing and
persistent use of dividends despite their relatively unfavorable tax treatment
suggests that repurchases have considerable economic costs that, in many
cases, are sufficiently large to outweigh their tax benefits.
Although repurchases are likely to be a less efficient payout
mechanism than dividends, this paper does not advocate restricting their
use. Instead, the paper proposes a new approach to the regulation of
repurchases that would reduce their potential efficiency costs without
reducing any of their potential benefits, and thus make repurchases a more
efficient cash-distribution mechanism. Under this approach, firms would be
required to disclose intended repurchases before effecting them. In previous
work I have shown that requiring individual insiders to disclose their
intended trades in advance would substantially reduce insiders= ability to
trade profitably on inside information.6 Requiring firms to disclose in
advance their intended repurchases would also diminish managers= ability
to use repurchases to indirectly trade on inside information and thereby
reduce the resulting investment, payout, and disclosure distortions.7 At the
same time, such a disclosure requirement would not affect repurchases’
ability to provide financial flexibility, signaling, lower transaction costs, and
shares for option plans.
The paper concludes by briefly considering some of the implications
of the analysis for the debates over the optimal taxation of dividends and the
6 See Jesse M. Fried, Reducing the Profitability of Corporate Insider Trading Through
Pretrading Disclosure, 71 S. Cal. L. Rev. 303 (1998).
7 Pre-repurchase disclosure would not be required, however, if the repurchase is
conducted by a person or organization that does not have access to inside information
about the firm, or by the corporation itself according to a disclosed, pre-arranged plan
that is not entered into or cancelled at a time when managers have inside information.
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proper accounting treatment of employee options. There is evidence that the
current tax subsidy provided to repurchases and the absence of dividend
protection in managers’ options are significant factors in the use of
repurchases, and may lead shareholders and managers to prefer repurchases
even though they may well be less efficient than dividends. From an
efficiency perspective, it may well be desirable to reduce or eliminate these
distortions. The tax distortion could be reduced by diminishing the implicit
tax subsidy for repurchases, which in turn could be accomplished either by
increasing the taxation of repurchases or by reducing the taxation of
dividends. The analysis thus suggests an additional argument for recent
proposals to lower the taxation of dividends. The accounting distortion
could be eliminated either by requiring that all employee options including
those without dividend protection, to be expensed, or by not requiring any
employee options, including those with dividend protection, to be expensed.
The analysis thus offers another reason in favor of recent proposals to
expense all employee options.
The remainder of the paper is organized as follows. Part II describes
the increasing importance of repurchases as a payout mechanism, and the
two factors believed to be most responsible for this trend: (1) the implicit tax
subsidy currently accorded repurchases; and (2) the structure of managers’
options compensation, which is likely driven by accounting considerations.
Part III demonstrates that any share repurchase is economically
equivalent to the corporation (1) causing remaining shareholders to buy the
stock of selling shareholders and (2) issuing a dividend. It systematically
analyzes the efficiency benefits and costs of share repurchases that arise from
the dividend component of a repurchase, and shows that the net efficiency
effect of the dividend component could be either positive or negative. It then
explains how the redistributional component transfers value between
remaining and selling shareholders.
Part IV identifies distortions arising from managers’ ability to
repurchase shares. It begins by explaining how managers can use
repurchases to buy stock at a low price and to use repurchase
announcements to boost the stock price before selling their shares. It then
describes the underinvestment, cash hoarding, and reduced disclosure that is
likely to result from the use of repurchases to transfer value to managers
from selling shareholders.
Part V critically examines the four benefits attributed to share
repurchases relative to dividends: (1) greater financial flexibility; (2) credible
share value signaling; (3) lower transaction costs; and (4) ―funding‖ of
employee option plans. It shows that all of these benefits can be achieved as
easily with a dividend and/or simpler and more efficient mechanism than a
repurchase.
-6-
Part VI considers the possibility that stock demand curve slope
downward. If stock demand curves are downward sloping, then managers
can also use repurchases (and not just repurchase announcements) to boost
the stock price before selling their shares. This increases the frequency of the
under-investment and cash-hoarding distortions that, as Part IV explained,
arise when managers use repurchases to buy stock at a low price.
Part VII considers the implications for the desirability of repurchases
of three empirical regularities: that markets react positively to repurchase
announcements, that corporate charters do not place restrictions on
managers’ ability to repurchase shares, and that firms continue to use
dividends despite their tax disadvantage. It explains why the first two
regularities – markets’ positive reactions to share repurchase announcements
and the failure of corporate charters to prohibit repurchases – do not indicate
that repurchases are an efficient mechanism for distributing cash and the
third regularities – the continuing use of dividends is consistent with it being
an inefficient mechanism for distributing cash.
Part VIII puts forward the pre-repurchase disclosure proposal and
shows that requiring firms to announce their repurchases in advance would
make it very difficult for managers to use repurchases to indirectly buy stock
at a low price. This, in turn, would reduce the distortions associated with the
use of repurchases to transfer value from selling shareholders – including
under-investment, cash-hoarding, and reduced disclosure. If stock demand
curves are downward sloping, such pre-repurchase announcements might
also reduce managers’ ability to boost the stock price by having the firm
repurchase shares, and the distortions that result from the use of repurchases
for that purpose. Part VIII also considers the tax and accounting policy
implications of the analysis. Part IX concludes.
II. TOWARD RECONSIDERING THE DESIRABILITY OF REPURCHASES
Section A describes the increasing popularity of share repurchases
and how they are currently regulated. Section B explains the implicit tax
subsidy accorded to repurchases and the accounting rules governing the
expensing of managerial options, both of which are believed to be important
factors behind the increasing use of repurchases rather than dividends to
distribute cash.
A. The Use and Regulation of Share Repurchases
Managers wishing to distribute cash to public shareholders must
either issue a dividend or repurchase shares. Over the last 20 years, the use
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of share repurchases to distribute cash has increased substantially in the U.S.,
increasing from $1.4 billion in 1980 to over $200 billion in 1998.8
The increase in the use of share repurchases appears to be coming, at
least in part, at the expense of dividends.9 The average payout/earnings
ratio for publicly traded US firms has remained fairly constant during the
period 1974-1998, at around 26-28%.10 During this period, the average
payout/earnings ratio for repurchases has increased from 3.7% to 13.6%, and
the average payout/earnings ratio for dividends has declined by an almost
equal amount, from 22.3% to 13.8%. 11
The increase in repurchases is due in part to more firms using
repurchases instead of dividends to distribute cash. The percentage of firms
initiating distributions that initiate distributions using repurchases rather
than dividends has increased from 27% in 1973 to 81% in 1998.12 It is also
due in part to firms that traditionally have payed dividends increasing their
repurchases dramatically while increasing their dividends at a much slower
rate.13 That is, funds that might have been used to increase dividends are
apparently being distributed through repurchases instead.
A share repurchase can take the form of an open market repurchase
(AOMR@), in which the corporation buys back its own stock on the market,
through a broker, or a repurchase tender offer (―RTO‖).14 The focus of this
paper is on OMRs, which are used to purchase approximately _____ $ of
8 See Gustavo Grullon & David L. Ikenberry, What Do We Know About Stock
Repurchases?, 13 J. APPLIED CORP. FIN. 31, 33 (2000); Scott Weisbenner, Corporate Share
Repurchases in the 1990’s: What Role Do Stock Options Play? 1 (working paper, 2000).
9 See, e.g., Gustavo Grullen and Roni Michaely, Dividends, Share Repurchases, and
the Substitution Hypothesis (working paper, 2001).
10 See Grullon and Ikenberry, What do we Know about Stock Repurchases?, J. APPLIED
CORP. FIN. (2000), at 41.
11 See Grullon and Ikenberry, What do we Know about Stock Repurchases?, J. OF
APPLIED CORP. FIN. (2000), at 41. Not all of the reduction in dividends is caused by the
increasing use of repurchases. See Eugene F. Fama and Kenneth R. French, Disappearing
Dividends: Changing Firm Characteristics or Lower Propensity to Pay, 14 J. OF APPLIED CORP.
FIN. 67 (2001) (attributing some of the reduction in dividends to changes in the mix of
publicly traded firms (more small firms with low earnings and high growth rates, which
tend not to distribute cash)). More recently, as other countries have begun removing tax
and regulatory impediments to share repurchases, there has also been a dramatic
increase in the use of buybacks outside the U.S. See, e.g., Peter Goldstein, European
Concerns Start to Warm Up to Share Buybacks: Firms Seek Outlets for Cash As Earnings
Improve, Interests Rates Decline, Wall St. J. Eur., June 23, 1998, at 17 (noting that
announced European buyback plans increased to $42.7 billion in 1997 from $14.2 billion
in 1996, in response to current and anticipated liberalizing of share repurchase laws).
12 See Grullon and Michaely, supra note x.
13 See Grullon and Michaely, supra note x. See also Fama and French, supra note x.
(finding a lower propensity to pay dividends among public firms)
14 See supra note x.
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shares per year, or 90-95% of the total amount of shares repurchased
annually.15
Under the rules of U.S. stock exchanges, firms are required to
announce the establishment of open market buyback programs.16 Such
announcements are usually greeted favorably by the market, and they are
associated with short-term ―abnormal‖ (i.e., market-adjusted) share price
increases averaging 3%-4%.17
However, OMRs are subject to very few disclosure (or other)
requirements. The repurchasing firm need not announce when it begins,
suspends, resumes, and completes its repurchase of shares. If a firm
announces an OMR, it will typically indicate the number of shares it intends
to repurchase,18 but at the same time make clear that the number of shares
that will actually be repurchased will depend on market conditions.19 As
result, the firm is not obligated to repurchase any shares. 20 On average,
OMRs target 7 percent of outstanding shares,21 and companies announcing
OMRs repurchase 70-80 percent of the targeted number of shares.22
However, a substantial number of corporations announcing OMRs never
repurchase a single share.23 Firms conducting OMRs usually complete them
over periods ranging from several months to several years. 24
One reason the use of share repurchases increased so dramatically in
the mid 1980s is that prior to 1983 managers feared that OMRs would subject
15 See Grullon & Ikenberry, supra note, at 33-34.
16 See Matthew J. Gardella, Stock Buybacks: Legal Issues Under the Federal Securities
Laws and Other Practical Considerations, 13 INSIGHTS 2 (1999).
17 See Ikenberry et al., supra note __, at 190 (reporting that the average market
reaction to OMR announcements in all of the OMRs announced between January 1980
and December 1990 by firms listed on the American Stock Exchange, New York Stock
Exchange, and NASDAQ was 3.54%).
18 Approximately 20-30% of firms don’t announce the number of shares they plan
to acquire. See Maxwell and Stephens (reporting that 20% don’t announce), at 6;
Jaganathan & Stephens, supra note x at 6 (reporting that 30% don’t announce).
19 See Ikenberry and Vermaelen, The Option to Repurchase Stock, 25 FIN. MAN. ___
(1996)(conceiving repurchase announcements as an option to repurchase if the stock
becomes underpriced).
20 Some firms announce an intention to undertake open market repurchases
without specifying a dollar amount or time limitation. See Grullon and Ikenberry, p. 33.
21 See Ikenberry, et. al., supra note, at 185 (reporting that the average percentage of
outstanding shares sought in all of the open market repurchases announced between
January 1980 and December 1990 by firms listed on the ASE, NYSE, and NASDAQ was
6.6 percent).
22 See Clifford P. Stephens and Michael S. Weisbach, Actual Share Reacquisitions in
Open-Market Repurchase Programs, 53 J. FIN. 313, 314 (1998).
23 See id.
24 See Stephens and Weisbach, supra note x. In contrast, RTOs, which target twice
as many shares, are completed within one month. See Fried, supra note x.
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them to liability for violating the anti-manipulation provisions of Section
9(a)(2) of the 1934 Act.25 However, in 1982, the SEC adopted a safe harbor
provision from anti-manipulation liability, Rule 10b-18,26 which provides
repurchasing firms a Asafe harbor@ from anti-manipulation liability under
Section 9(a)(2).27 The rule went into effect in 1983. Among other things, Rule
10b-18 requires a firm seeking the safe harbor to (1) limit the number of
shares it purchases on the open market each day to 25 percent of the average
daily trading volume of the previous month and (2) not offer a price that is
higher than the last sale price on the exchange or the current bid quote,
whichever is higher.28
Interestingly, most corporations fail to comply exactly with the
provisions of the Rule 10b-18 safe harbor.29 However, they tend to sharply
limit the number of shares repurchased per day in keeping with the ―spirit‖
of the rule.30
B. Tax and Options-Accounting Explanations for Repurchases
We now turn to the leading explanations for the increasing use of
repurchases: (1) their favorable tax treatment relative to dividends and (2)
the accounting treatment of managers’ options. Before proceeding to
consider each of these explanations in more detail, it is worth noting that
25 See Grullon and Michaely, supra note x at 5 (reporting that the amount of
repurchases had tripled one year after Rule 10b-18 was put in effect).
26 See 17 C.F.R. 240.10b-18 (1999).
27 Under Section 9(a)(2), it is illegal to conduct a series of transactions creating
actual or apparent active trading in a security, for the purpose of inducing the purchase
or sale of the security.
In releasing Rule 10b-18 the SEC made clear that it does not provide a safe
harbor from Rule 10b-5 liability. Sec. Ex. Act. Rel. 19,244 26 SEC Dock. 868, 869 n.5
(1982). Thus the issuer is not permitted to repurchase while in possession of favorable,
material, nonpublic information concerning its securities.
28 Other requirements are that open market purchases must be made through (a)
only one broker (per day); (b) at a time other than the last half hour of trading and (c)
after the opening transaction. Another legal risk facing the firm is that the OMR might
be considered a constructive repurchase tender offer, subjecting the firm to all of the
restrictions on RTOs described in Fried, supra note x. There is no safe harbor analogous
to Rule 10b-18 from liability resulting from a constructive tender offer. However,
because of the restrictions on price and volume, buybacks conducted under Rule 10b-18
are also not likely to be considered a "tender offer" for the purposes of the securities
laws. Edward Herlihy, et al., Financial Institutions Mergers and Acquisitions 393
(PRACTICING LAW INSTITUTE CORPORATE LAW AND PRACTICE HANDBOOK SERIES No. B4-
7179) (1997).
29 See, e.g., Krigman, Cook ___________.
30 Id.
- 10 -
these two explanations for the increasing use of share repurchases have
nothing to do with the efficiency of share repurchases relative to that of
dividends. Thus, the fact that repurchases have become so popular does not,
by itself, provide evidence that share repurchases are more efficient than
dividends.
1. The Implicit Tax Subsidy for Repurchases
An important reason for repurchases’ popularity is that, under current
tax rules, they are taxed less heavily than dividends. 31
When the firm issues a dividend, all taxable shareholders are taxed at
ordinary income rates on the amount of dividend they receive. In contrast,
when the firm repurchases shares, only those shareholders who choose to
sell their shares are taxed. In addition, those selling shareholders are taxed at
the capital gains rate, which in most cases is less than the ordinary income
rate to which dividends are subject. Finally, these selling shareholders are
not taxed on the full amount of the sale proceeds, but rather only on the
difference between the sale proceeds and the shareholders’ cost basis in the
stock.
Consider a taxable shareholder who owns shares of ABC Corp. in a
taxable brokerage account. When ABC Corp. issues dividends, the
shareholder has taxable income equal to 100% of the dividends he receives.
That income is taxed at the rate at which ordinary income is taxed. Thus if
the shareholder receives $100 in dividends he must pay tax on those
dividends at his marginal combined federal and state income tax rate. If his
marginal combined rate is 40%,32 the shareholder receiving the $100
dividend must pay $40 in taxes, leaving him with $60.
When ABC Corp. repurchases shares, the tax burden on the
shareholder is much lighter. If the shareholder chooses not to sell any of his
31 See Eugene F. Fama and Kenneth R. French, Disappearing Dividends: Changing
Firm Characteristics or Lower Propensity to Pay, 14 J. APPLIED CORPORATE FINANCE 67
(2001) (claiming that the decline in propensity among firms to pay dividends is due to
tax reasons). For evidence that the decision to repurchase shares rather than issue
dividends is partially tax-driven, see Indudeep S. Chhachhi & Wallace N. Davidson III,
A Comparison of the Market Reaction to Specially Designated Dividends and Tender Offer Stock
Repurchases, 26 FIN. MGMT. 89, 93-94 (1997). See also Grullon and Michaely
(2000)(finding that market reaction to a repurchase announcement are higher when the
expected tax benefits are higher); Erik Lie and Heidi Lie, The Role of Personal Taxes in
Corporate Decisions: An Empirical Analysis of Share Repurchases and Dividends, 34 J. FIN.
QUANTITATIVE ANALYSIS ___ (1999) (finding . . . ) [RA: complete cite].
32 The top marginal federal tax rate on ordinary income is ____ (as of December
2002).
- 11 -
shares, he has no taxable income and accordingly pays no taxes. If, on the
other hand, the shareholder sells his shares, he has taxable income only to
the extent that the sale price exceeds his cost basis in the stock. In addition,
that income would be taxed at the capital gains rate, which is often more
favorable than the tax rate for ordinary income.
Suppose, for example, that the shareholder sells to ABC Co. or another
buyer in the market $100 worth of ABC stock that he had purchased for $20.
The shareholder would be taxed only on the difference between the sale
price ($100) and his cost ($20), which is $80. Suppose that the marginal
combined federal and state tax rate for these capital gains is 25%. 33 In that
case, the shareholder would pay only $20 in taxes, leaving him with $80 ($20
more than if ABC Corp. had issued $100 of dividends to the shareholder).
Thus the tax system effectively provides a subsidy to share repurchases.34
2. The Options Accounting Bias Towards Repurchases
Another widely accepted reason for the increasing use of repurchases
rather than dividends lies in the historic accounting treatment accorded
different types of employee stock options. Currently, firms need not take an
accounting charge against reported earnings when they issue employee
options whose strike price is fixed at or above the grant-date market price.
However, the firms must take a charge against earnings when they issue
employee options whose strike price could change over time. Thus, almost
every public firm gives managers fixed-price options.
The value of managers= fixed-price options is in large part based on
the difference between the current stock price and the fixed exercise price.
The stock price, in turn, reflects the per share value of the firm (the total
value of the firm divided by the number of outstanding shares). Thus, a
reduction in per share value of the firm reduces the stock price, which in
turn reduces the value of managers’ options.
A dividend will tend to reduce the value of manager’s options. By
removing cash from the firm, the dividend reduces the total value of the
firm, without reducing the number of outstanding shares. This reduces per
share value and, in turn, the stock price. And a lower stock price makes
managers= options less valuable.
A share repurchase also removes cash from the firm, reducing the
total value of the firm. However, the repurchase also reduces the number of
outstanding shares. Thus, a repurchase does not reduce per share value if the
reduction in the firm=s value is offset by the reduction in the number of
33 The top federal marginal rate on long-term gains is _____ (as of ___________).
34 See Amy K. Dittmar, Why Do Firms Repurchase Stock?, 73 J. BUS. 331, 334 (2000).
- 12 -
shares outstanding. As a result, distributing the cash through a repurchase
does not necessarily lead to a reduction in per share value and the stock
price. In fact, if managers can have the firm buy back stock at a price below
its actual value, a repurchase will increase per share value and thereby boost
the stock price. For example, if the firm distributes 10% of its value and buys
back 10% of its shares, per share value and the stock price should remain
unchanged (everything else being equal).35 But, if the firm could buy back
10% of its shares by distributing 8% of its value, a repurchase could increase
per share value, the stock price, and therefore the value of managerial
options. Thus, unlike dividends, repurchases do not necessarily reduce the
value of managerial options, and could in fact increase them.
Because of the asymmetrical effects of dividends and repurchases on
the value of fixed-price options, most option-compensated managers are
personally better off using repurchases rather than dividends to distribute
cash. And, as the use of options in executive compensation has dramatically
increased over the last 20 years, so has the incentive to repurchase shares
rather than issue dividends.36 There is evidence that the increasing use of
repurchases is in fact driven, at least in part, by the increasing use of
options.37
To be sure, one could eliminate the asymmetric effect of dividends
and repurchases on managerial options. In particular, one could protect the
value of managerial options from dividends by reducing the option’s
exercise price by the amount of any dividend. Such ―dividend-protection‖
would eliminate the distortion in favor of repurchases arising from the
existing structure of managerial options. However, dividend protection
would make the exercise price variable and therefore force the firm to
expense managers’ options on its income statement. This in turn would
reduce accounting earnings, which might affect the stock price or perhaps
draw unwanted attention to the value of the options issued to managers.38
35 In Parts III and IV we will see how a repurchase can increase or decrease the
total amount of value available to shareholders and thereby affect per share value.
36 See George W. Fenn & Nellie Liang, Corporate Payout Policy and Managerial Stock
Incentives (Fed. Reserve Sys., Fin. & Econ. Discussion Series Paper No. 1999-23, Mar.
2000); Christine Jolls, Stock Repurchases and Incentive Compensation (NBER Working Paper
No. 6467, 1998).
37 See Kathleen M. Kahle, When a Buyback isn’t a Buyback: Open Market Repurchases
and Employee Options (working paper, 2001)(finding that the decision to repurchase
shares is affected by the number of managerial options outstanding); Fenn and Lang,
supra note x; Jolls, supra note x.
38 See Bebchuk, Fried and Walker, Managerial Power and Rent Extraction in the
Design of Executive Compensation, 69 U. CHI. L. REV. 751 (2002).
- 13 -
Thus, 99% of firms using stock option plans do not dividend-protect the
options.39
An alternative explanation for the lack of dividend protection relates
to the tax efficiency of repurchases: shareholders (acting through the board)
might be attempting, by depriving managers of dividend protection, to give
managers an incentive to repurchase shares rather than issue dividends. If
this were true, then there would be only a single reason for the increasing
use of share repurchases: the tax system. In any event, there is evidence that
the lack of dividend protection in options does create a bias in favor of
repurchases.40
III. Reconceiving a Repurchase as a Redistribution Coupled to a
Dividend
Section A puts forward a reconceptualization of a repurchase as a
redistribution coupled to a dividend. Section B examines the dividend
component of a repurchase and its potential efficiency benefits and costs.
Section C considers the effects of the redistributional component.
A. The Reconcepualization
The paper now puts forward a reconceptualization of a share
repurchase that will help make salient the economic differences between a
repurchase and a dividend. As this Section will show, a share repurchase
can be reconceptualized as a three-part transaction involving trading among
shareholders, a dividend, and a reverse stock split. In particular, a
repurchase is identical in effect to a three-step transaction in which the
corporation (1) causes nonselling shareholders to purchase the stock of
selling shareholders41 at the repurchase price; (2) issues a dividend equal to
the amount of the repurchase; and (3) effects a reverse stock split.42
A diagram can be used to illustrate the equivalence between a share
repurchase and this three-step transaction.
39 See Kevin Murphy, Executive Compensation, in Handbook of Labor Economics (O.
Ashenfelter & D. Card, eds.) (1998).
40 Bartov, Krinsky and Lee, supra note x (cited in Kahle) find that the presence of
dividend protection affects managers’ decision whether to repurchase shares or issue a
dividend.
41 By ―selling shareholders,‖ I mean those selling shareholders whose shares are
purchased by the repurchasing firm.
42 For now, I ignore transaction costs, which would be lower under a repurchase
than under the threestep transaction described here. I will address this potential
advantage of repurchases in Part V.C.
- 14 -
Repurchase = Shareholder Exchange + Dividend + Reverse Stock
Split
Corp XYZ Corp XYZ Corp XYZ Corp XYZ
= + +
1 share $100 $100 2 shares 1 new
share
1 share
A B A B A A
1 share 1 share $100 2 shares
Result
A owns 1 share giving it 100%
ownership of Corp. XYZ after
XYZ distributes $100
B gets $100
Suppose that XYZ Corp. has 2 shareholders, A and B, each of whom
owns one share. The figure to the left of the ―=‖ shows a stock repurchase in
which XYZ repurchases B’s share for $100. The effect of the repurchase is
that (1) B has sold his share for $100; (2) XYZ has distributed $100 in cash;
and (3) A owns XYZ’s single share (100% of XYZ’s equity).
The figures to the right of the ―=‖ show a three-step transaction: First,
A buys B’s share for $100. Second, XYZ distributes a dividend of $100 to A
(to reimburse A for his purchase of B’s share). Third, XYZ effects a reverse
stock split by converting A’s 2 existing shares into 1 new share.
It is easy to see that the results of this three-step transaction are
identical to those of the single-step transaction on the right: (1) B ends up
with $100 and no shares in XYZ; (2) XYZ has distributed $100 in cash; and (3)
A owns XYZ’s single share (100% of XYZ’s equity).
Because the reverse stock split is merely a nominal change with no
economic significance, for purposes of the analysis we need to focus only on
the first two steps of this three-step transaction: (1) the redistributional
component (in which nonselling shareholders buy the stock of selling
shareholders) and (2) the dividend component. Because of the economic
equivalence between a share repurchase and these two steps of the
transaction, a share repurchase can be conceived as having two types of
economic effects: the economic effects that flow from the dividend
component of the transaction and the economic effects that flow from the
redistributional component of the transaction. Reconceptualizing a share
repurchase=s effects in this way makes it clear that the only economic
differences between a dividend and a share repurchase are those that arise as
- 15 -
a result of adding the redistributional component. In the next several Parts,
we will see that coupling a redistribution to a dividend can give rise to a
variety of distortions, without providing any unique benefits.
Before we consider these differences, however, it will be useful to first
examine the potential efficiency consequences of a dividend -- and therefore
the potential efficiency consequences arising from the dividend component
of a repurchase. We now turn to this subject.
B. The Dividend Component of a Repurchase
As Section A explained, a share repurchase can be reconceptualized as
a redistributional transaction (the remaining shareholders’ purchase of
shares from departing shareholders at the repurchase price) coupled to a
dividend (a pro-rata distribution of cash).
The purpose of this Part is to highlight an important point for the
analysis of the efficiency benefits and costs of repurchases that will follow:
that the dividend component of a repurchase (by itself) can either reduce or
increase social value. To that end, this Section shows that the dividend
component of a repurchase can generate both efficiency benefits and
efficiency costs.
As we will see, the dividend components generates efficiency benefits
and efficiency costs primarily through two mechanisms. First, the dividend
makes capital that would have been used by the firm available to
shareholders for investment outside the firm. Second, the dividend increases
leverage, which in turn can alter managerial incentives, particularly those
relating to managerial effort levels and project choice. As we will see, there
could be efficiency costs or efficiency benefits associated with each of these
effects -- the reallocation of capital and the alteration of managerial
incentives. Thus, the dividend component of the repurchase can either
increase or decrease social value, depending on the direction and magnitude
of these various efficiency effects. The fact that the social value of the
dividend component could be negative or positive is important because -- as
Part IV explains -- one of the potential costs associated with the coupling of
the redistributional component to the dividend component is that it might
induce managers to conduct repurchases whose dividend-component
reduces social value or induce managers to forego a repurchase whose
dividend component increases social value.
I first examine the capital-reallocation effect of the dividend
component. I then consider the impact of the dividend component on
managerial incentives through its effect on the firm’s leverage. Finally, I
explain how the net effect of the dividend component on social value could
be either positive or negative.
- 16 -
1. Reallocation of Capital
The first mechanism by which a repurchase’s dividend component
can affect social value is through its effect on the allocation of capital. Every
potential investment has an expected return. The expected returns from the
firm’s projects may well differ from the expected returns from other
investments available to the firm’s shareholders. 43 Thus, the dividend
component of a repurchase can affect social value by shifting cash from the
firm’s projects to investments outside the firm. 44
When the firm=s projects have lower expected returns than projects
outside the firm, distributing cash is value increasing.45 Funds that would
generate higher returns outside of the corporation are often called ―excess‖
(or ―free‖) cash. 46 In the U.S., there is evidence that firms use both dividends
and the dividend component of share repurchases to distribute excess cash.47
When a firm=s projects have higher expected returns than the
alternative investments available to its own shareholders, distributing cash is
value-wasting. Call the funds that could be better used in the firm
Aneeded@ cash.
2. Increase in Leverage
The second mechanism by which a repurchase’s dividend component
can affect social value is by altering managerial incentives. In particular, the
43 Managers may not have an incentive to pursue the best projects available to the
firm if the private benefits available from alternative investments (such as a new
corporate jet or fancy office building) are sufficiently high. Thus the social value created
or destroyed by moving funds from corporate to non-corporate projects depends on the
actual projects foregone by the repurchase, and not necessarily the best project available
to the firm. It should also be noted that the cash distributed can also be used for
consumption. The assumption that the cash distributed is used for investment is made
to facilitate the exposition and does not affect any of the analysis.
44 A repurchase moves funds from corporate to noncorporate projects only to the
extent it is not funded with debt incurred for that purpose. To the extent the repurchase
is financed with such debt, the amount of funds available for projects in and outside the
corporation is not affected. However, even if the firm finances the repurchase entirely
out of funds borrowed for that purpose, the repurchase and borrowing would still
increase leverage, the second mechanism through which the repurchase’s dividend
component generates efficiency costs and benefits. See infra Part III.B.2.
45 In determining whether the cash distribution is value increasing, one would also
need to take into account the effect of the distribution on the expected costs associated
with financial distress.
46 See, e.g., Michael Jensen, Agency Costs of Free Cash Flow, Corporation Finance and
Takeovers, 76 AMERICAN ECON. REV. 323 (1986).
47 See Dittmar, at 333-335. See Grullon and Ikenberry, supra note x, p. 40.
- 17 -
dividend component increases leverage, which in turn alters managers’
incentives to (1) exert effort and (2) choose one project over another.
From an efficiency perspective, it would be desirable for managers to
run firms in a way that maximizes social value. In such a world, managers
would choose projects that maximize total wealth. And they would exert an
amount of effort such that the marginal social benefit of additional effort
equals the marginal social cost (including the cost to them personally).48
As is well understood, however, managers= incentives are not fully
aligned with value maximization. Two types of distortions are relevant for
our purposes. First, managers do not capture the full benefit of their efforts
because they own only a fraction of the equity, and thus have an incentive to
work less than would be socially optimal, that is to Ashirk@. Second, to the
extent managers are risk averse, they may forego positive expected value
projects with a high likelihood of failure in favor of lower value projects with
a lower likelihood of failure. The reduction in social value that results from
each of these distortions is called an Aagency cost.@49
As I explain, the magnitude of these effort and project-choice
distortions and the resulting agency costs are affected by the likelihood of
failure. That likelihood is in turn is affected by the firm’s leverage – its
debt/equity ratio.50 The repurchase’s dividend component inevitably
increases the firm’s leverage. Thus, the dividend component affects the
likelihood of failure and, indirectly, managers’ effort and project choice.
The manner in which the dividend component increases the risk of
failure depends on how the repurchase is funded. If the dividend is funded
with new debt, the firm is obligated to make additional interest payments,
which increases the likelihood that the firm will not be able to make these
payments in bad times. If the dividend is not funded with new debt, the
managers will have fewer assets with which to make payments on any old
debt. In either case the likelihood of failure increases. 51 As explained below,
48 More precisely, they would choose a (projects, effort level) combination that
maximizes social value.
49 There is a third type of distortion that can arise. In particular, to the extent that
(a) value can be transferred from creditors to equityholders and (b) managers represent
the interests of equityholders, managers may have an incentive to (1) undertake higher-
risk, lower value projects or (2) distribute needed cash (by a repurchase or dividend) in
order to transfer value from creditors to equityholders. This distortion is similar to the
distortion caused by risk aversion – except in the opposite direction.
50 See, Dittmar, supra note x at 335. See Grullon and Ikenberry, supra note x
(suggesting that firms repurchase shares to offset reduction in leverage caused by
issuing shares to employees.) Cf. Armen Hovakimian, The Role of Target Leverage in
Security Issues and Repurchases (working paper, 2001) (concluding that firms do not
conduct equity repurchases for the purpose of changing their leverage).
51 Another cost of increasing leverage is that is increases the expected costs
- 18 -
by increasing leverage and the risk of failure, the dividend component of a
repurchase can mitigate or exacerbate each of the two distortions described
above.
a. Effect on Managerial Shirking
Managers have an incentive to work less and take less care than is
optimal because they enjoy 100% of the benefit of their Ashirking@ but pay
(through the reduction in the value of their shares) only a small fraction of
the cost of their shirking to the firm.
In theory, shareholders could monitor managers and adjust the salary
of, or even terminate, managers they find to be shirking. Were such
monitoring effective, it would deter shirking. But in practice, it will be
difficult to determine whether a particular manager is shirking (and if so, to
what extent). Furthermore, the transaction costs involved in replacing
management through a proxy contest are very high.52 Thus, even if
shareholders could more easily detect shirking they would have an incentive
to punish managers only in an extreme case.53 Because most shirking is
either unobservable or observable but unpunishable, managers will not be
deterred from shirking, and the reduction in shareholder value that results
from shirking could be significant.
The dividend component should reduce shirking by raising the cost to
the managers of shirking. Specifically, the distribution increases the cost of
shirking by making shirking more likely to lead to the firm not being able to
pay its debts -- a crisis that could threaten managers= jobs. The increased
likelihood of failure should give managers an incentive to focus harder on
generating revenues and cutting costs, making the corporation more
efficient.54 Thus, the dividend component of a repurchase should provide an
efficiency benefit by reducing managerial shirking.
b. Effect on Project Choice
In addition to the incentive to shirk, managers may have an incentive
to forego high-risk projects in favor of lower-risk lower-return projects.
Managers tend to place a high value on keeping their jobs – because of the
associated with financial distress and bankruptcy. See supra note x (discussing this point
in Part III.A.)
52 See Bebchuk and Kahan, A Framework for Analyzing Proxy Contests, __CAL. L.
REV. ___(1990).
53 In an extreme case the managers may also face a hostile takeover bid.
54 Shirking will also be reduced if new debt is incurred and the new creditors are
better suited for monitoring managers than the existing shareholders. See Buckley,
supra note x, at _____.
- 19 -
salary, perquisites, power, and prestige that come with high level positions
in public firms. To the extent a high-risk project increases the likelihood that
the firm will fail (or at least do poorly), that project increases the chance that
managers will lose these valuable jobs. Thus, to managers the expected
costs of initiating a high-risk, high return project may appear extremely high
– and may outweigh whatever benefits the managers expect to get from the
project qua shareholders.
Because the dividend component of a repurchase increases the
likelihood of failure, either form of cash distribution could exacerbate the
problem of risk aversion by making managers even less likely to undertake
value-increasing projects that happen to be risky.
3. Net Dividend Effects of a Repurchase
This Section has considered the efficiency effects of the dividend
component of a repurchase. As we have seen, the dividend component
affects social value through its effects on (1) the allocation of capital, (2)
managerial effort (which is likely to be positive); and (3) project choice
(which is not likely to be positive).
Whether or not the dividend component of a particular share
repurchase increases social value will depend on the directions and relative
strengths of the various effects. For example, the dividend component of a
repurchase might distribute excess cash but worsen managerial incentives
(on balance). In such a case, the net effect on social value depends on
whether the increase in value that results from distributing excess cash
outweighs the decrease in value resulting from the worsened incentives.
For purposes of this paper, however, the direction and relative
magnitude of these various effects is not important. What is important is
that the dividend component of a repurchase can either increase or reduce
social value.
C. THE REDISTRIBUTIONAL COMPONENT OF A REPURCHASE
Having examined the efficiency consequences of the dividend
component of a repurchase, we now turn to consider in more detail the
redistributional effect of a repurchase on remaining shareholders. I first
examine the situation in which the actual value of the stock is the same as the
repurchase price. I then consider both the situation in which the stock’s
actual value is lower than the repurchase price and that in which it is higher.
- 20 -
To focus on the redistributional aspect of a repurchase, I will assume
in this Part that the dividend component of the repurchase has no efficiency
effects. In the next Part, I examine the interaction between the dividend and
redistributional effects of a repurchase when the dividend component does
have efficiency effects. There I will show that the redistributional effects of a
share repurchase can lead managers to conduct a repurchase where the
dividend component is value-decreasing or cause managers to forego a
repurchase when the dividend component would be value-increasing.
1. Effect when Repurchase Price Equals Stock’s Actual Value
We first consider the redistributional effect of a repurchase when the
actual value of the stock equals the repurchase price. As Section A
explained, a repurchase is equivalent to (1) the remaining shareholders
purchasing the shares of departing shareholders at the repurchase price and
(2) the firm issuing a dividend to remaining shareholders. When the actual
value of the shares is the same as the repurchase price, the ―purchase‖ of the
share does not transfer value between the remaining shareholders and the
departing.
A simple example can be used to illustrate this point.
Corp XYZ = Corp XYZ + Corp XYZ
$200 $100 $200 $200 $100
1 share $100 $100
$100
A B A B A
1 share 1 share 1 share 2 shares
worth $100
Result
A gets 100% of Corp.
XYZ (worth $100)
B gets $100
- 21 -
Suppose again that XYZ Corp. has 2 shareholders, A and B, each of
whom owns one share. Now suppose that the pre-distribution value of XYZ
(it’s value before distributing cash to shareholders) is $200. Each share is
thus worth $100.
The figure to the left of the ―=‖ shows a stock repurchase in which
XYZ repurchases B’s share for $100. The effect of the repurchase is that (1) B
has sold his share for $100; (2) XYZ has distributed $100 in cash; and (3) A
owns XYZ’s single share (100% of XYZ’s equity), which is worth $100 ($200
pre-distribution value less $100 paid to B).
The figures to the right of the ―=‖ show a two-step transaction: First,
A buys B’s share for $100. Second, XYZ distributes a dividend of $100 to A
(to reimburse A for his purchase of B’s share). The exchange component of
the transaction has no distributional effect because A is buying B’s share for
its proper value -- $100. Thus, both A and B end up with cash or stock worth
$100.
2. Effect when Repurchase Price Exceeds Stock’s Actual Value
Now consider the situation in which the actual value of the stock is
less than the repurchase price. Suppose, for example, that there is bad news
not yet reflected in the stock price.
As Section A explained, a repurchase’s redistributional effect is
equivalent to the that of the remaining shareholders purchasing the shares of
departing shareholders a the repurchase price. When the stock’s actual value
is less than the repurchase price, the repurchase thus transfers value from
remaining to selling shareholders. In effect, the remaining shareholders buy
the shares of departing stockholders at an inflated price.
When the stock’s actual value is below the repurchase price, the
amount of the transfer from remaining shareholders equals the difference
between the repurchase price and the actual value of the stock, multiplied by
the number of shares repurchased. The remaining shareholders bear the cost
of the transfer pro rata. Thus, the higher is a shareholder’s proportional
ownership, the greater the cost borne by that shareholder.
Now suppose that the pre-distribution value of XYZ is not $200 but
rather $150. Each share is thus worth $75.
- 22 -
Corp XYZ = Corp XYZ + Corp XYZ
$150 $50 $150 $150 $50
1 $100 $100
share
A B A $100 B A
1 share 1 share 2 shares
1 share
worth $75
Result
A gets 100% of Corp.
XYZ (worth $50)
B gets $100
The figures to the left of the ―=‖ show a stock repurchase in which
XYZ repurchases B’s share for $100. The effect of the repurchase is that (1) B
has sold his share for $100; (2) XYZ has distributed $100 in cash; and (3) A
owns XYZ’s single share (100% of XYZ’s equity), which is worth $50 ($150
pre-distribution value less $100 paid to B).
The figures to the right of the ―=‖ show a two-step transaction: First,
A buys B’s share for $100. Second, XYZ distributes a dividend of $100 to A
(to reimburse A for his purchase of B’s share). The trading component of
the transaction redistributes value between A and B because A is buying B’s
share for $100, even though it is actually worth only $75. A and B each
started with stock worth $75. The $25 transfer from A to B means that B ends
up with $100 and A ends up with $75.
3. Effect When Repurchase Price Below Stock’s Actual Value
Finally, consider the opposite situation – that in which the actual
value of the stock is greater than the repurchase price. Suppose, for example,
that there is undisclosed good news which, when released, will cause the
stock price to increase.
- 23 -
The repurchase’s redistributional effect is, again, equivalent to that of
the remaining shareholders buying the shares of departing shareholders at
the repurchase price. When the stock’s actual value exceeds the repurchase
price, the repurchase therefore transfers value from departing to remaining
shareholders. In effect, the remaining shareholders buy the shares of
departing stockholders at a bargain price.
When the stock’s actual value is above the repurchase price, the
amount of the transfer to remaining shareholders equals the difference
between the actual value of the stock and the repurchase price, multiplied by
the number of shares repurchased. The remaining shareholders enjoy the
transfer pro rata. Thus, the larger is a shareholders’ proportional ownership,
the greater is his share of the transfer.
For example, now suppose that the pre-distribution value of XYZ is
$300. Each share is thus worth $150.
Corp XYZ = Corp XYZ + Corp XYZ
$300 $200 $300 $300 $200
1 share $100 $100
$100
A B A B A
1 share 1 share 1 share 2 shares
worth $50
Result
A gets 100% of Corp. XYZ
(worth $200)
B gets $100
The figures to the left of the ―=‖ show a stock repurchase in which
XYZ repurchases B’s share for $100. The effect of the repurchase is that (1) B
has sold his share for $100; (2) XYZ has distributed $100 in cash; and (3) A
owns XYZ’s single share (100% of XYZ’s equity), which is worth $200 ($300
pre-distribution value less $100 paid to B).
The figures to the right of the ―=‖ show a two-step transaction: First,
A buys B’s share for $100. Second, XYZ distributes a dividend of $100 to A
- 24 -
(to reimburse A for his purchase of B’s share). The exchange component of
the transaction redistributes value between A and B because A is buying B’s
share for $100, even though it is actually worth only $150. A and B each
started with stock worth $150. The $50 transfer from B to A means that B
ends up with $100 and A ends up with $200.
IV. THE PROBLEMS WITH COUPLING A REDISTRIBUTION TO A DIVIDEND
In Part III, I explained how the repurchase’s redistributional effect can
transfer value to or from remaining shareholders. This Part examines the
distortions that can arise because of the repurchases’ redistributional effect.
Section A describes the considerable amount of evidence indicating that
managers do use the redistributional effect to transfer value from selling
shareholders to themselves and other remaining shareholders when the
actual value of the stock exceeds the repurchase price. Section B then
describes the distortions that can result from managers’ use of repurchases
for this purpose.
A. Managers’ Use of the Redistributional Effect to Enrich Themselves
This Section explains why managers have the incentive and ability to
use the repurchase redistributional effect for the benefit of themselves and
other remaining shareholders, and presents evidence that they indeed do so.
1. Managers’ Incentive to Transfer Value to Themselves and Remaining
Shareholders
As Part III.C. explained, when the stock’s actual value exceeds the
repurchase price, the repurchase transfers value from departing shareholders
to remaining shareholders. The value transferred is shared ratably among
the remaining shareholders. Thus, to the extent managers retain their shares,
the repurchase benefits them. Everything else equal, managers holding
shares in the firm would therefore have an incentive to conduct such a
repurchase.
The benefit to the managers is increasing in the total amount
transferred and the managers’ proportional interest in the post-repurchase
firm. As a result, the higher managers’ proportional ownership, the greater
the incentive to repurchase shares when the stock’s actual value exceeds the
- 25 -
repurchase price.
In fact, managers of firms announcing repurchases tend to own a
substantial fraction of the firms’ shares before the repurchase: an average of
15-20%.55 In fact, managers capture an average of one out of every five or
six dollars of value transferred from selling shareholders to remaining
shareholders, providing them with significant incentive to conduct
repurchases when the stock is underpriced. Moreover, there is a positive
relationship between pre-repurchase managerial ownership and post-
repurchase stock appreciation,56 suggesting that managers with larger stakes
are more likely than managers with smaller stakes to conduct a repurchase
when the stock is underpriced.
2. Managers’ Ability to Transfer Value to Themselves and Remaining
Shareholders
a. Access to Inside Information
What types of information can managers trade on? There is
considerable evidence that managers have important private information
relating to firm value by virtue of their positions within their firms. The most
persuasive evidence is that managers are able to exploit private information
about firm value to increase their personal trading profits. Managers
increase their selling before releasing ―bad news‖ and increase their buying
before releasing ―good news.‖57 For example, corporate insiders sell heavily
in the five-month period preceding a bankruptcy announcement.58 Corporate
insiders also tend to frequently exercise options shortly before stock price
declines.59 Finally, corporate insiders as a group consistently earn excess
returns in their personal trading.60 One study found that in their personal
trading between 1984 and 1989, which includes, presumably, trades not
based on inside information (e.g., liquidity-driven sales), managers annually
55 See McNally, supra note , at 59; Vafeas, supra note , at 112-13.
56 See Raad and Wu, Insider Trading components on Stock Returns Around Open-
Market Repurchase Announcement: An Empirical Study, 18 J. FIN. RES. 45, 57 (1995) (finding
that abnormal returns following repurchases are positively related to pre-buyback
insider buying and the level of pre-buyback management ownership).
57 See Fried, supra note x, at 317-20 (collecting and summarizing studies).
58 See Thomas Gosnell et al., Bankruptcy and Insider Trading: Differences Between
Exchange-Listed and OTC Firms, 47 J. Fin. 349, 350-53 (1995); H. Nejat Seyhun & Michael
Bradley, Corporate Bankruptcy and Insider Trading, 70 J. Bus. 189 (1997).
59 See Steven Huddart & Mark Lang, Information Distribution Within Firms: Evidence
from Stock Option Exercises (working paper, 2001).
60 See Fried, supra note x, at 321-23 (collecting and summarizing studies).
- 26 -
earned excess returns averaging 7%. 61
To the extent managers can use inside information to increase their
personal trading profits, they can also use this information to benefit
themselves and other remaining shareholders by having the firm repurchase
stock at a bargain price. Indeed, there are a number of factors that make it
easier for managers to buy indirectly through repurchases than to buy
directly for their own accounts when the stock is underpriced.
First, liquidity constraints might make it difficult for managers to buy
shares for their own accounts, or buy as many shares as they would like.
Such liquidity-constrained managers might purchase shares in the market to
the extent permitted by their liquidity constraints and, after they have
reached those constraints, conduct a repurchase. In fact, managers
frequently do buy shares for their own accounts before announcing
repurchases.62
Second, section 16(b) of the Securities Exchange Act of 1934, which
prohibits managers (but not the firm) from making ―short swing profits,‖
might prevent managers from buying shares.63 A corporate insider is
considered to make a short-swing profit if he or she buys stock and sells
stock within a six-month period, the purchase price is lower than the sale
price. The rule applies not only when the purchase precedes the sale, but
also when the sale precedes the purchase. A manager who either has sold
shares at a higher price within the previous six months or expects to sell
shares at a higher price within the next six months will expect to face section
16(b) liability if he buys stock on the market. However, indirect purchases of
stock through a share repurchase are not subject to section 16(b). Thus, such
a manager will not face section 16(b) liability if he indirectly buys stock
through a repurchase.
Third, many firms restrict the trading of managers and directors
through the use of ―trading-windows‖ and ―blackout‖ periods, which permit
corporate insiders to trade only during certain prescribed periods
throughout the year.64 Thus some managers may be subject to firm-imposed
trading restrictions at a time when they believe the stock to be underpriced
and wish to purchase shares. Because of these three types of restrictions,
managers may often prefer (or be forced) to buy shares indirectly through a
61 See H. Nejat Seyhun, The Effectiveness of Insider Trading Sanctions, 35 J.L. & Econ.
147, 158-60 (1992).
62 See Elias Raad & H.K. Wu, Insider Trading Effects on Stock Returns Around
Open-Market Stock Repurchase Announcements: An Empirical Study, 18 J. FIN. RES.
45, 57 (1995).
63 15 U.S.C. § 78p(b) (2001).
64 See J. Carr Bettis et al., Corporate Policies Restricting Trading by Insiders, 57 J.
Fin. Econ. 191 (2000).
- 27 -
repurchase in addition to, or instead of, buying shares for their own
accounts.
b. The Law’s Inability to Prevent Managers’ Use of Inside
Information
There are, of course, legal restrictions that apply to managers and
firms trading on ―inside information.‖65 One might wonder, then, how
managers are able to use their private information to either buy shares for
their personal accounts or have their firms buy shares at a low price.
The most important legal restriction on insider trading is Rule 10b-5,
which was promulgated by the SEC under section 10 of the Securities
Exchange Act of 1934.66 Rule 10b-5 requires that any insider (including the
corporation itself) with a fiduciary duty to those with whom the insider
would trade refrain from trading if in possession of ―material‖ inside
information.67 Rule 10b-5 thus appears on its face to prevent the managers
from repurchasing shares when they know the stock is underpriced.
However, as I have shown elsewhere,68 there are likely to be many
cases in which Rule 10b-5 cannot prevent insiders – including the
corporation – from trading profitably on inside information. Rule 10b-5
prohibits trading on inside information only when that information is legally
―material.‖69 And much inside information is not legally material. First,
internal projections and other forms of ―soft‖ information are not considered
legally material, even if the information is important and would be of great
interest to investors.70 Thus, managers are free to trade and to conduct share
repurchases without disclosing a wide range of valuable but inside
65 By Ainside information,@ I mean nonpublic information relating to the value of
the firm=s shares that is available to managers by virtue of their positions within the
corporation, whether or not that information would be considered legally Amaterial.@
66 17 C.F.R. § 240.10b5 (2000).
67 See Fried, supra note x, at 330.
68 See Fried, supra note x.
69 See United States v. O’Hagan, 521 U.S. 642, 643 (1997).
70 For example, in Walker v. Action Indus., 802 F.2d 703 (4th Cir. 1986), managers
conducted a repurchase tender offer (RTO) for $4.00 per share and three months later
the market price rose to $15.75. The court found that there was no violation of the
securities laws even though at the time of the RTO there were undisclosed forecasts
predicting a substantial increase in orders and sales. See also John Coates, A Fair Value as
an Avoidable Rule of Corporate Law: Minority Discounts in Conflict Transactions, 147 U.PA.
L. REV. 1251, 1315 (1999) [RA: add parenthetical]; Mitu Gulati, When Corporate Managers
Fear a Good Thing is Coming to an End: The Case of Interim Nondisclosure, 46 UCLA L. REV.
675, 682 (1999) (reporting that recent case law and the SEC’s position is that companies
are not obligated to disclose forecasts).
- 28 -
information.71 Second, courts have been reluctant to find even non-soft
information ―material‖ unless it concerns a ―bombshell event‖—such as the
definite existence of a takeover offer—whose announcement dramatically
changes the stock price.72 Thus, the threshold of materiality is such that
insiders can easily profit by trading directly or indirectly through
repurchases on information that, while price-sensitive, is not legally
material.73
c. Why the Required Repurchase Announcement Doesn’t Fully Reveal
the Underpricing
If the firm has not already announced the initiation of an open market
repurchase program, then before repurchasing any shares the firm must,
under stock exchange rules, announce the initiation of the program. The
announcement will, in turn, boost the stock price, narrowing the gap
between the share price and the stock’s actual value, and making it more
difficult for the managers to profit by buying the shares of selling
shareholders.74
However, it is unlikely to close the gap because the ―signal‖ sent by
the announcement is ambiguous. The firm might simply be giving itself the
option to repurchase shares should they become underpriced in the future.75
For example, Continental Airlines recently announced a program that is of
indefinite duration, perhaps obviating the need to ever announce such a
program again.76 Or, as I will explain shortly, the managers might be
announcing the program simply to boost the stock price before selling their
own shares.77 Knowing that these are possible reasons for the announcement,
71 See Fried, supra note, at 310; Robert Clark, supra note, at 507-08 (noting that
managers may have access to bits of information that individually are not important
enough to be considered legally material but which in aggregate are very valuable);
Donald Langevoort, Rereading Cady, Roberts: The Ideology and Practice of Insider Trading
Regulation, 99 COLUM. L. REV. 1319, 1335 (1999) (observing that [i]nsiders at almost all
times have the advantage of superior insight and a sense of which way things are going
even if they do not possess a fact that a court would call material and nonpublic).
72 See Fried at 336.
73 See Dennis W. Carlton & Daniel Fischel, The Regulation of Insider Trading, 35 Stan.
L. Rev. 857, 886-87 (1983). There are also situations in which the probability of detection
and punishment for illegal insider trading is so low that managers may well not be
deterred from engaging in it. See Fried, supra note x at 331-335.
74 In Part VI, I consider the possibility that stock repurchases might boost the stock
price by taking stock out of the hands of the lowest-valuing shareholders. To the extent
repurchases exert such price pressure, the gap will be narrowed further.
75 See Ikenberry and Vermaelen, supra note x.
76 See Grullon and Ikenberry, supra note x.
77 See infra Part IV.C.
- 29 -
the market’s reaction will be muted -- even if the market is perfectly efficient.
In fact, the shares of firms announcing repurchases exhibit large
abnormal returns in the months and years following the announcement.
This indicates that the market on average underreacts to the information
signaled by the repurchase announcement (that is, the stock price does not
adjust to reflect all of the information available about its value). Because the
market underreacts to the repurchase announcement, it is even easier for
managers to benefit themselves and remaining shareholders by buying
shares through the firm when the stock is underpriced.78
d. Cash and Flexibility Constraints on Repurchases
That is not to say that managers have an almost unlimited ability to
use the redistributional effect of repurchases to transfer value to remaining
shareholders. To begin, the firm might face cash constraints. That is, it
might not have enough cash on hand to fully exploit a temporary gap
between the actual value of the stock and the share price. Alternatively, the
firm might have the cash, but prefer to use it for other (real) investments that
are likely to earn remaining shareholders an even higher return. These cash
constraints will limit managers’ ability to exploit mispricing.79
In addition, even if the firm is not cash-constrained, the firm might
be reluctant to buy a large number of shares in a short period of time. There
could be two reasons for such reluctance. First, managers might fear that
large purchases will signal that the stock is underpriced, forcing the price of
the stock up and significantly reducing the amount of value transferred to
remaining shareholders.80
Second, managers might wish to comply – or substantially comply –
with Rule 10b-18, which provides a safe harbor from manipulation liability
for firms which limit the daily volume of their repurchases and adhere to
other restrictions. Either of these concerns will limit managers’ ability to
exploit mispricing even if they are not cash constrained.
3. Evidence Managers Use Repurchases to Transfer Value
Having seen that managers have the incentive and ability to use a
repurchase’s redistributional effect to benefit remaining shareholders, we
78 See infra Part IV.B.3.
79 The firm might be able to raise funds by issuing debt, but there is likely to be a
time lag during which the stock might become fairly priced (or even overpriced). In
addition, the costs of issuing additional debt (e.g., excessive leverage) might exceed the
expected benefit from buying the stock at a low price.
80 The firm might also fear that the purchases will exert price pressure. See infra
Part VI.
- 30 -
now turn to the considerable evidence that is consistent with managers using
repurchases to transfer value from selling shareholders to remaining
shareholders. The evidence can be divided into two categories: (1) price
movements before, around the time of, and in the years following the
repurchase announcement; and (2) managers’ behavior before, during, and
after the repurchase announcement.
Consider first the stock prices of firms announcing repurchases. The
stock prices of firms announcing repurchases on average exhibit negative
abnormal returns in the period prior to the announcements 81, which is
consistent with the shares having been underpriced at the time of the
repurchase.82 When the repurchase is announced, the market reacts to the
announcement by bidding up the price of the stock. This reaction is
consistent with the announcement sending a signal that the stock is
underpriced.83 Finally, and most importantly there are abnormal price
increases averaging 12% over the forty-eight months following repurchase
announcements.84 These post-repurchase returns provide extremely strong
evidence that as a group, firms announcing OMRs are underpriced at the
time the repurchase is announced.85
81 Jagannathan and Stephens, supra note x report that for infrequent or occasional
repurchasers (firms which conducted only 1 or 2 repurchases respectively in the
previous 5 year period) average returns in the year before the announcement are 11%
and 5%, respectively, below those of peer firms.
82 Firms announcing first time repurchases have high book to market ratios, which
is consistent with their being underpriced. See Grullon and Ikenberry, supra note x.
Of course, the negative abnormal returns prior to the repurchase announcement
do not prove that the stock was underpriced at the time of the announcement. It is
possible that the stocks were overpriced prior to the negative abnormal returns and
that those negative abnormal returns simply corrected the overpricing.
83 Of course, the positive reaction to the repurchase announcement does not prove
that the market infers from the announcement that the stock is underpriced. There are a
number of reasons why the stock price might increase in response to such an
announcement. For example, the announcement might signal that managers are finally
willing to distribute cash for which they have no good investment opportunities. Part
VII.A. provides a number of other non-informational explanations why a repurchase
announcement might boost the stock price.
84 See Ikenberry, Lakonishok, and Vermaelen, supra note, at 190 (reporting large
price increases following OMRs undertaken between 1980 and 1990). See also Chan,
Ikenberry and Lee, Do Managers Knowingly Repurchase Stock on the Open Market
(examining long-horizon returns for a sample of over 4000 open market programs
announced by US firms from 1980 to 1996 and finding [RA: complete]) (working paper,
2000).
85 The subsequent abnormal price increases do not prove that the stock is
underpriced at the time of the repurchase announcement because there could be
another explanation for the post-announcement price increases: that firms conducting
- 31 -
Next consider managerial behavior. First, there is some evidence that
managers buy more shares for their personal accounts before repurchases
that are followed by significant stock price appreciation, 86 suggesting that
they are aware that the stock is underpriced prior to the announcement.
Second, firms are more likely to follow up a repurchase announcement with
actual repurchases if the stock performs poorly.87
4. A Note on Managers’ Use of Repurchase Announcement to Boost the Stock
Price Before Selling
We have seen that managers can -- and do -- use the redistributional
effect of repurchases to transfer value to remaining shareholders when the
actual value of the stock exceeds the stock price. Market participants are not
unaware of this fact. Thus, market participants are likely to infer from a
repurchase announcement that the stock may be underpriced, and bid up the
price of the stock upon hearing the announcement. 88
Of course, not all repurchases are motivated by managers’ desire to
transfer value to remaining shareholders. There are likely to be repurchases
that have other motivations. For example, managers may repurchase shares
in order to distribute excess cash in a tax efficient manner, or as we will see
in more detail, to ―fund‖ option programs. Thus investors cannot be certain
that a particular repurchase is motivated by managers’ desire to purchase
stock for themselves and remaining shareholders at a low price.89
repurchases boost the price of their shares by buying back shares from their lowest-
valuing shareholders. This possibility is discussed infra Part VI.
If price pressure does not explain at least part of the subsequent abnormal stock
price increases, then the underreaction to repurchase announcements is quite puzzling,
as it seems to provide investors with significant arbitrage opportunities which, when
exploited, would tend to increase the reaction to the repurchase announcements and
reduce the subsequent abnormal price increases (in other words, arbitrage should
accelerate those price increases so that they occur when the repurchase is announced,
rather than after).
86 See Raad and Wu, Insider Trading components on Stock Returns Around Open-
Market Repurchase Announcement: An Empirical Study, 18 J. FIN. RES. 45, 57 (1995)
(showing that abnormal returns following OMRs are positively related to pre-buyback
insider buying and the level of pre-buyback management ownership). But see Chan,
Ikenberry, Lee (finding no evidence that managers buy around repurchases that
precede large price increases)(working paper, 2000).
87 See Stephens and Weisbach, supra note x.
88 There are other reasons that market participants might react favorably to a
repurchase announcement besides the signal it sends about the actual value of the stock.
For example, investors might bid the price up because they believe the firm will
distribute excess cash that it had been holding and that was earning poor returns.
89 Interestingly, there is evidence that the reaction is lower when the market
believes that the repurchase is intended to fund option plans. In particular, the reaction
- 32 -
However, even if many repurchases are motivated by other reasons a
repurchase announcement signals that the expected value of the stock is likely
to be higher than the pre-announcement market price. This, in turn, suggests
that managers intending to sell shares might announce a repurchase in order
to boost the price of the stock before selling the shares, even if they have no
immediate intention of repurchasing any shares.
To be sure, average stock price reactions to repurchase
announcements is fairly modest, 3-4%. 90 However, there are abnormal
returns averging 7-8% when smaller firms announce repurchases and when
the announcement has not been preceded by another in the last five years. In
any event, for managers selling millions of dollars worth of shares, as well as
managers exercising options whose strike price is close to the pre-
announcement market price, the ability to sell shares at even a slightly higher
price may well be significant. Essentially, managers who wish to sell shares
attempt, by announcing a repurchase, to "mimic" or "pool" with managers of
underpriced firms who are using a repurchase to buy stock at a low price.
To the extent that the market cannot distinguish between the different types
of firms, the repurchase announcement boosts the stock price, enabling the
mimicking managers of to sell their shares at a higher price.91 The presence
of overpriced firms in the pool of firms announcing repurchases dampens
the price reaction to repurchase announcements. This price-dampening
inures to the benefit of managers of underpriced firms, by enabling them to
buy shares for themselves and other remaining shareholders at a lower price.
Thus, mimicking by selling managers of indirectly buying benefits all
managers announcing repurchases.
There is evidence consistent with the use of repurchase
announcements to boost the stock price before managers sell shares: at least
one study reports that mean and median insider percentage ownership fall
around the time of repurchase announcements.92 In addition, Jagannathan
is lower when there are a large number of employee options outstanding. See
______Kahle, supra note x, at 6. See infra Part __ for a discussion of the need for
repurchases to fund option plans. See also Jagannathan and Stephens, Motives for
Multiple Open-Market Repurchase Programs (working paper, 2001)(reporting that the stock
market reaction to first time repurchases is higher than that to multiple repurchases by
the same firm in a 5 year period, presumably because the firm conducting multiple
repurchases has different motives for repurchasing – such as distribution of excess cash
and acquisition of shares to fund option programs).
90 See supra note.
91 Cf. Bhattacharya & Dittmar, supra note, at 27 (reporting that there is no
difference in market reaction between OMR announcements followed by repurchases
and OMR announcements not followed by repurchases).
92 See Vafeas, supra note. In addition, Chan, Ikenberry, and Lee find that
repurchase announcements occur around time executive options are exercised.
- 33 -
and Stephens find that although the average post-repurchase returns of
infrequent and occasional repurchasers are positive, the median is
significantly negative relative to the market, which is consistent with many
firms having been overpriced.93 Because it is unlikely that in all of these
overpriced firms managers were planning to repurchase shares, and given
managers’ tendency to sell when they know the stock is overpriced, it is
likely that at least some of these repurchase announcements were made by
managers solely with the intent of boosting the stock price before selling
their shares.
B. Potential Distortions
This Section describes the potential distortions that can result from
managers’ use of repurchases to transfer value from public shareholders.
Section A describes what I call the ―under-investment distortion;‖ when the
stock is sufficiently underpriced, managers may have an incentive to conduct
a repurchase even when from an efficiency perspective the cash is better
invested in the firm. Section B describes the second distortion likely to arise
from the use of repurchases to transfer value: that managers are likely to
maintain excessively large cash reserves (―the cash-hoarding distortion‖).
Third, as Section C explains, repurchases can give rise to an ―under-
disclosure distortion‖ - managers may have an incentive to delay the
disclosure of important information.
1. Underinvestment
We saw that the dividend component of a repurchase could either be
efficient or inefficient – depending on the direction and magnitudes of its
two effects: (1) the cash-distribution effect; and (2) leverage-altering effect.
The first problem with coupling a redistributional transaction to a dividend
is that it might encourage managers to conduct repurchases whose dividend
component is not value-decreasing.
Consider the case in which the managers have private information
about the value of the stock and know that the stock is underpriced. In that
case, the managers know that, if they repurchase shares, the redistributional
component of the repurchase is going to make remaining shareholders –
including the managers – better off. In essence, a repurchase would cause
the remaining shareholders to buy the shares of selling shareholders at a low
price. To the extent that the managers continue to hold shares – they will
93 See Jagannathan and Stephens, Motives for Multiple Open-Market Repurchase
Programs (working paper, 2001).
- 34 -
have an incentive to repurchase shares, everything else equal.
Of course, everything is not equal. The managers will also consider
the value that can be created by the dividend component of the repurchase.
In particular, they will consider the possibility that a repurchase can be used
to distribute excess cash or improve leverage. If the dividend component
would create value, then the managers would have a stronger incentive to
conduct a repurchase because it boosts the value of remaining shares in two
ways – by creating value and transferring value from selling shareholders.
However, if the dividend component reduces value – the managers
may still have an incentive to repurchase shares. Specifically, they will
repurchase shares if the value transferred to selling shareholders exceeds the
value created by the repurchase for remaining shareholders.
Suppose that A and B each own 50% of XYZ Corporation. The market
values XYZ at $200, or $100 per share. However, the manager (A) knows that
XYZ is actually worth $300. In the absence of a repurchase, A’s 50% interest
is worth $150 (1/2 x $300). But A contemplates having XYZ Corporation
repurchase B’s share for $100, $50 less than it is actually worth. In the
absence of an efficiency effects, such a repurchase would transfer $50 to A
(by leaving him with 100% of a firm worth $200).
However, suppose there would be some efficiency costs to such a
repurchase. Specifically, suppose that such a repurchase would reduce XYZ’s
value by an extra $25 (beyond the $100 paid out to B) because XYZ would
need to forego certain high value projects in order to ―finance‖ the
repurchase. Nevertheless, A decides to go forward with the repurchase,
because at the end of the repurchase he will own 100% of a firm worth $175,
while in the absence of a repurchase his interest would be worth only $150.
Corp XYZ = Corp XYZ + Corp XYZ
$300 $175 $300 $300 $175
1 share $100
$100
$100
A B A B A
1 share 1 share 2 shares
1 share worth $150
- 35 -
There is some evidence consistent with repurchases reducing firm
value. A recent study comparing repurchasing firms in the U.S. to
nonrepurchasing firms found that the nonrepurchasing firms’ stock
outperformed that of repurchasing firms. The authors reported that the
higher investments by nonrepurchasing firms in working capital and capital
projects were largely responsible for the performance gap.94
To be sure, a firm might be able to borrow money to fund the
repurchase, which would reduce the problem of distributing cash better
invested in the corporation. But borrowing might be difficult, either because
bond covenants prohibit or because it takes too much time, during which the
underpricing might disappear. And even if borrowing were possible,
managers might not want to increase the firm’s interest burden and the
likelihood of financial distress.
2. The Cash-Hoarding Distortion
Another distortion that can arise from the use of repurchases is
excessive liquidity – maintaining cash reserves that are too large. The
reserves are too large in the sense that they money would be better invested
outside of the firm. However, from the perspective of remaining
shareholders, it might make sense to keep the cash in the firm because
managers know, or think likely, that the stock price will fall below its actual
value (by over-reacting to bad news) or that there will be good news that will
not be reflected in the stock price), and having cash available in the firm is
necessary to take advantage of that discrepancy.
As will be explained, the problem of cash-hoarding also arises when
the stock is overpriced and for that reason managers do not repurchases
shares. That is, managers might have an incentive not to conduct a (value-
increasing) repurchase even though the dividend-component is value-
increasing because they have private information indicating that the stock is
94 See John Evans and James Gentry, ―Do Strategic Share Repurchase Programs
Create Long-Run Firm Value‖ p. 24 (working paper, 2000). See also Robert O’Brien,
―Stock Buybacks Gain Popularity, But Price Pops Aren’t Guaranteed‖, Wall St. Journal
p. 17 Column 3 (3/6/00) (citing research report by chief investment strategist of Credit
Suisse First Boston as saying that ―heavy repurchases are counterintuitively associated
with poor share performance‖). Of course, it is not clear in which direction causality
runs. It is possible that poorly performing companies without attractive investment
possibilities are more likely to distribute (excess) cash than companies with better
opportunities.
- 36 -
overpriced and thus decide to postpone the repurchase until the stock is
correctly priced or underpriced.
a. Waiting for the Next Insider Trading Opportunity
Suppose that ABC Co, with 10 shares outstanding has $V in operating
assets and $10 in cash. Suppose that $V = $180 or $0 with equal likelihood.
Managers will learn the value at the beginning of next period, before the
public. Right now the stock has an expected value of $10 and (let us assume)
is trading for $10.95 The $10 in cash sitting in the firm will generate $0
during the current period. If it is distributed, the $10 in cash will generate $1
of profit. (Assume that if the $10 is invested in the firm’s operations it also
generates no return).
From an efficiency point of view, the $10 should be distributed. But
the managers and other remaining shareholders are better off if the $10 is not
distributed, but rather kept in the firm so that if $V = 180, and the shares are
actually worth $19 per share, they can buy a share for $10 and boost the
value of their shares to $20.
b. Waiting for an Overpriced Stock to Fall
Now consider the case in which the managers have private
information about the value of the stock and know that the stock is
overpriced. And suppose the only method available for ABC’s managers to
distribute cash is a share repurchase. (I will justify this assumption shortly).
In that case, the managers know that if they repurchase shares the
redistributional component of the repurchase is going to make remaining
shareholders – including the managers – worse off. In essence, a repurchase
would cause the remaining shareholders to buy the shares of selling
shareholders at an inflated price. To the extent that the managers’ interests
are aligned with those of remaining shareholders – because they continue to
hold shares – they will have an incentive not to repurchase shares,
everything else equal.
Of course, everything is not equal. The managers will also consider
the value that can be created by the dividend component of the repurchase.
Again, they will consider the possibility that a repurchase can be used to
distribute excess cash or improve leverage. If the dividend component is
95 Because of the possibility that the managers will decide to purchase the stock
when it is underpiced, the price will be slightly discounted from $10. But I ignore this
complication because it does not affect the analysis.
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value-reducing, then the managers will certainly not conduct a repurchase.
Under this scenario, there would be no problem of excessive payouts.
However, now – if the dividend component creates value – they will
have an incentive to repurchase shares only if the value created by the
repurchase for remaining shareholders exceeds the value transferred to
selling shareholders. If the dividend component would create value but less
than the value transferred to selling shareholders, the managers will not
have an incentive to conduct a repurchase. Instead, they will wait until the
stock price falls sufficiently to make the repurchase worthwhile and then
distribute the cash. During this interim period, when the repurchase is
delayed, there is an efficiency cost.
We were assuming in this subsection that the only way to distribute
cash is through a repurchase. If we relax that assumption, when the stock is
overpriced, the firm could simply issue a dividend which has no
redistributional component. This would solve the problem of the delayed
cash distribution.96 However, such a dividend would signal that the stock is
overpriced and cause the price to fall, making it difficult for managers to sell
their own shares at as high a price. Thus managers might not issue a
dividend even if it would be efficient to do so.
C. Reduced Disclosure
In Part III.B we saw that share repurchases can, through the dividend
component, affect managerial effort and project-choice ex post -- that is, after
the transaction. Share repurchases -- and in particular the use of repurchases
for insider trading - can also affect managerial incentives ex ante. In
particular, when managers know that they may later have an opportunity to
use a share repurchase to indirectly buy the stock at a low price or sell it at a
high price, their managerial incentives could become distorted.
In particular, the use of share repurchases to buy low and sell high
encourages managers to invest in projects that are difficult for outsiders to
assess, whether these projects are otherwise desirable or not, in order to
increase the information asymmetry between themselves and public
shareholders so they can make more money buying low or selling high.97 In
addition, the use of share repurchases for insider trading can cause managers
to distort or withhold information, or to mislead the public, especially
96 See Bhagwan Chowdhry and Vikram Nanda, Repurchase Premia as a Reason for
Dividends: A Dynamic Model of Corporate Payout Policies, 7 REV FIN STUD 321
(1994)(arguing that dividends allow corporations to distribute cash more cheaply when
the stock is overvalued).
97 See Fried, supra note x, at ___.
- 38 -
around the time of the share repurchase, in order to maximize the
information asymmetry between the managers and public shareholders.98
V. ARGUMENTS FOR REPURCHASES
In Part III we saw that a repurchase can be decomposed into a
dividend and a redistributional component and therefore that a repurchase
can give rise to all of the potential efficiency benefits and costs of a dividend.
Part III.B elaborated on those costs and benefits associated with the dividend
component and showed that the dividend component of a repurchase could
be either value-creating or value-destroying. Part IV showed that the
redistributional component of the repurchase could distort the payout and
investment policies of the firm by encouraging managers to repurchase
shares when a payout is value-reducing and maintain excessive liquidity
when a payout of the funds in the firm would be value-increasing. In
addition, the use of repurchases could reduce disclosure.
This Part considers the possibility that there might be countervailing
benefits unique to repurchases whose existence should be considered in
determining the desirability of share repurchases relative to dividends. The
finance literature suggests four types of efficiency benefits associated with
repurchases but not dividends.
First, repurchases might provide firms with more financial flexibility
than dividends (Section A). Second, repurchases are said to allow firms to
credibly signal information about the value of the shares (Section B). Third,
repurchases might impose fewer transaction costs on shareholders than do
dividends (Section C). Fourth, repurchases are said to be necessary for
providing shares for stock option incentive plans (Section D).
Each of these benefits will be examined in turn. As will be explained,
each of these benefits is achievable solely with dividends or more efficiently
accomplished with dividends and some other mechanism. It is important to
emphasize here that I am not suggesting that repurchases be prohibited. I am
claiming, however, that if repurchases were prohibited all of the efficiency
benefits could easily be achieved through other mechanisms.
98 In this way, using the share repurchases for insider trading may have the same
adverse effects on price efficiency as Apersonal@ insider trading, which gives managers
an incentive to delay disclosing information to the market or to deliberately provide the
market with misleading information. See Fried, supra note x, at n.54 and surrounding
text.
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A. Financial Flexibility
The first benefit attributed to repurchases is financial flexibility. It
has been argued that share repurchases give firms more financial flexibility
than dividends because paying a dividend implies to the market a
commitment to make future distributions.99 Thus when there is a one-time
need to distribute cash, firms cannot issue dividends because that would
falsely raise investors= expectations about the future cash flow of the firm. In
fact, there is evidence that firms with transient positive cash flow shocks use
repurchases rather than dividends to distribute the cash.100
The main problem with this explanation is that for decades firms have
used so-called Aspecial@ (one-time) dividends to distribute cash in situations
where the cash flow used to finance the dividend was not likely to be
recurring. Because a special dividend could be used in place of a repurchase,
repurchases are not necessary to give a firm financial flexibility.
B. Share-Value Signaling
A second possible benefit of repurchases is share-value signaling.
Specifically, managers who have private information indicating that the
stock is underpriced and wish to signal credibly that the stock is underpriced
can use the redistributional component of a share repurchase to do so by
conducting a repurchase and committing not to sell their shares. 101
As this Section will explain, however, share-value signaling is
inconsistent with managers’ interests and managers never use repurchases to
signal in this manner. Furthermore, if managers wished to engage in such
signaling, they need not conduct a repurchase to do so.
1. The Potential Benefit
To the extent that managers seek to maximize shareholder wealth,
they will wish to communicate good news to the market to boost the stock
price. However, direct disclosure of the good news is not always possible. 102
99 There is a considerable literature explaining how firms that initiate or increase
dividends send a signal to the market that long-term cash flows have increased. See, e.g.,
John and Williams (1985); Bernheim (1991); DeAngelo, DeAngelo, and Skinner (2000).
100 See Guay and Harford, supra note x. See DeAngelo, DeAngelo, and Skinner,
supra note x; Jagannathan, Stephens, and Weisbach, supra note x (finding that firms that
pay dividends have more stable earnings than firms that use repurchases and that
concluding that firms use repurchases to pay out transitory earnings while dividends
are used to payout permanent earnings).
101 See, e.g., Buckley, supra note, at 539.
102 For example, explicit disclosure might be harmful to the firm for competitive
- 40 -
When direct disclosure is not possible, the managers could instead
simply announce that the stock is underpriced. However, some
commentators believe that signaling is not credible unless it imposes
substantial costs on managers when the stock is not actually underpriced.103
According to these commentators, there is no cost to a manager who falsely
announces that the stock is underpriced.104 An announcement that the stock
is underpriced would therefore not be credible, and would be ignored or at
least highly discounted.105
To credibly signal underpricing, these commentators believe that
managers must act in a way that imposes substantial costs on them if the
stock is not actually underpriced. And these costs must be high enough that
a would-be false signaler would find the signal too costly to send.106
In theory, repurchases can be used to credibly signal that the stock is
worth more than the repurchase price. As we saw any share repurchase
distributionally equivalent to a transaction in which remaining shareholders
collectively buy shares directly from the selling shareholders at the
repurchase price. Thus managers who make a double commitment -- to (1)
have the firm repurchase shares and (2) not sell their own shares until the
underlying good news emerges --- effectively commit to buy their pro rata
share of the repurchased shares at the repurchase price. If firm value is in
fact less than the repurchase price, the repurchase makes managers worse off
by causing them to overpay for the shares.107 Thus by committing to
repurchase shares and to not sell their own shares, managers send a credible
signal that firm value exceeds the repurchase price. 108
Note that for the share repurchase to be a credible signal that the stock
is underpriced, managers must pledge that they will not sell any shares until
the good news signaled by the repurchase is supposed to materialize.109
Otherwise, managers would have an incentive to conduct a share repurchase
when the stock=s actual value is below the repurchase price, indicate that
they will not sell during the repurchase and thereby, falsely signal good
reasons or prohibited by a confidentiality agreement. See Buckley, supra note 16, at 536-
37.
103 See id.
104 See, e.g., id. at 527.
105 Lawless et al, supra note x have also pointed out that fear of legal liability might
prevent managers from disclosing information or beliefs directly to shareholders. See
Lawless, supra.
106 See Buckley, supra note, at 527. See also Spence.
107 By distributing cash, the repurchase also increases risk to the firm, imposing an
additional risk-bearing cost on managers. See McNally, supra note, at 56.
108 See William J. McNally, Open Market Stock Repurchase Signaling, [finish
citation].
109 See Fried (2001).
- 41 -
news, and then sell their shares at a high price after the signal has caused the
market price to rise.
2. The Irrelevance of Share-Value Signaling Through Repurchases
a. Managers Lack an Incentive to Signal Share Value
Consider managers= incentives to signal. Implicit in the signaling
theory is that managers have an incentive to use repurchases to signal
underpricing. But signaling usually requires managers to act contrary to
their self-interest. To begin with, the commitment to retain shares required
by signaling imposes a liquidity constraint on managers. Managers’ stock in
their own firms may well constitute a large fraction of the managers’ assets.
From time to time, managers might have liquidity needs that can be met only
by selling large amounts of these shares. Thus, the commitment to retain
shares that is required by the theory for credible signaling110 could impose a
liquidity cost.
In addition, signaling hurts managers by reducing their ability to
profit from their private information when they know that the stock is
underpriced. By not signaling, managers can keep the stock price
temporarily low. The low stock price enables managers to profit by buying
shares for themselves, either directly or indirectly through a repurchase, at a
price below their actual value. If the managers were to use a repurchase to
signal that the stock is underpriced, the market would bid up the stock price.
This, in turn, would make it more difficult for managers to buy shares for
themselves at a low price. 111
We have just seen that a repurchase signaling hurts managers by
constraining their financial flexibility and reducing their ability to buy shares
at a low price. Let us now consider the possibility that repurchase-signaling
can benefit managers by boosting the stock price, thereby enabling managers
to sell their shares at a higher price than would otherwise be possible. As the
analysis below will make clear, signaling cannot benefit managers in this
manner. The reason is that the managers must be net buyers for the (or at
least not net sellers) for the signal to be credible.
110 As will be explained shortly, managers can credibly signal without pledging to
retain all of their shares. However, for a typical one they must pledge to retain 90-95%of
their shares.
111 To be sure, managers signaling underpricing with a repurchase could still profit
to the extent the market fails to bid the stock price up to its actual value. However, the
managers would be better off not signaling underpricing and buying the shares at an
even lower price. See Fried, supra note x.
- 42 -
Thus, for the repurchase announcement to credibly signal the
existence of good news, the managers must pledge to retain almost all of
their shares until the good news itself emerges. Because managers must
retain almost all of their shares until the good news is revealed, they cannot
use repurchase-signaling to sell their shares at a higher price beforehand.
Whether or not they engage in repurchase-signaling, managers must wait
until the good news itself emerges before they can sell their shares at a
higher price.
But if managers must be net buyers at the repurchase price for the
signal to be credible, they are better off not credibly signaling that the stock is
underpriced, selling shares in the market at a lower price, and indirectly
buying a greater number of shares through an OMR. That is, the managers
are better off being net buyers at a lower price than at the higher, signaling-
induced price.112
To be sure, one can imagine situations in which managers can gain by
increasing the stock price through signaling. To the extent that the signal
boosts the stock price, it makes a takeover more difficult, makes it easier to
use stock to acquire another firm, and enables managers to borrow more
against their shares if the price is higher.
But given that managers always accrue some benefit from not
signaling – for example, they don’t impose restrictions on their trading --
they have an incentive not to signal until and unless there is a specific reason
to do so – such as a hostile takeover attempt. At that point, they can release
the information directly (even though it is not optimal for the firm and its
shareholders) or conduct a repurchase and use it to signal their own beliefs.
In other words, a strategy of not signaling can always be changed if a specific
threat of a hostile takeover or the opportunity of an acquisition arises.
Of course, this discussion is purely hypothetical because, as we will
shortly see, insiders never use open market repurchases to repurchase in the
manner suggested by the share-value signaling theory.
b. Managers Don’t Use Repurchases for Share-Value Signaling
Let us now examine whether in fact managers use the trading
component of repurchases for the purpose of signaling. The data easily
answer this question: they do not.
As explained above, for managers to use the trading component of
share repurchases to signal that the stock is underpriced managers must (1)
112 See Fried, supra note x and numerical examples therein.
- 43 -
indicate the price the corporation is paying for its shares; (2) indicate that a
substantial number of shares will be repurchased, and (3) commit not to sell
their shares for the Aacceleration period@ (the time it would take for the
hidden Agood news@ to emerge on its own).
In fact, managers do not indicate the price that the firm will be paying
for its shares or commit to purchasing a certain number of shares in the
repurchases or even commit to holding on to their own shares.
To begin with, signaling requires firms announcing repurchases to
commit to repurchase a certain number of shares. However, when making
repurchase announcements, managers never commit to purchase a minimum
number of shares.113 Although a repurchase announcement might specify a
target number of shares, the announcing firm makes clear that the actual
number of shares repurchased will depend on market conditions and on
managers’ discretion.114 Approximately 20-30% don’t even indicate the
target amount.115
In fact many firms announcing repurchases subsequently issue shares,
usually to employees and managers exercising stock options. Thus even
those that repurchase X% do not increase managers’ proportional ownership
X%, but rather by X-y%, where y is the stock issued after the repurchase
announcement. In some cases the amount of shares issued could exceed the
shares repurchased. Under circumstances like this, managers proportional
ownership could actually go down in the period following the repurchase
announcement.
One might believe that managers who announce a repurchase and do
not repurchase any shares suffer some form of reputational cost (unless the
failure to repurchase can be explained by, for example, a sharp increase in
the price immediately after the announcement). If so, a repurchase
announcement might represent an implicit commitment by managers to
repurchase shares unless circumstances would make such a repurchase
undesirable. However, 25% of firms announcing repurchases do not
113 See Ikenberry & Vermaelen, supra note, at 10.
114 See id.; Clifford P. Stephens & Michael S. Weisbach, Actual Share Reacquisitions in
Open-market Repurchase Programs, 53 J. Fin. 313 (1998). To be sure, there might be a good
reason for not explicitly committing to repurchase a specific number of shares. Were the
stock price to shoot up unexpectedly after a repurchase announcement, the firm might
find itself obligated to buy back shares for more than the shares are worth. However, if
managers wished to use a repurchase for credible signaling, they could attempt to solve
this problem. For example, managers could make the repurchase commitment
conditional on the stock remaining below a certain target price. Managers’ failure to try
to use repurchase announcements to make more binding commitments to repurchase
stock suggests either that managers have no interest in using repurchases for credible
signaling or that repurchases are inherently unsuited for this purpose.
115 See Maxwell and Stephens, at 6 (other paper says 30%).
- 44 -
repurchase a single share.116 It is highly unlikely that, in most of these cases, a
sudden change in conditions immediately after the repurchase
announcement thwarted managers’ intention to repurchase shares. Thus, as
other researchers have also concluded, repurchase announcements cannot be
considered credible commitments to repurchase shares.117
Not only do managers announcing repurchases fail to commit to
repurchase shares, they also fail to commit to retain their own shares.
Consequently, even if there were an explicit or implicit commitment by the
firm to repurchase shares, the repurchase announcement would not be a
credible signal of underpricing. Indeed, managers often sell shares in the
market around a repurchase. Managerial share ownership (as a fraction of
outstanding shares) actually declines around as many repurchases as it
increases. In fact, at least one study reports that both mean and median
insider ownership (as a percentage of outstanding shares) drop around the
time of repurchases.118 This decline in insider ownership means that in at
least 50% of repurchases, managers sell more shares in the market than they
indirectly buy through the repurchase.119
3. The Availability of Other (Better) Mechanisms for “Credible”
Share-Value Signaling
Credible share-value signaling is unlikely to require the use of a
repurchase.
There are two other, more simple mechanisms that can achieve the
same result. First, managers could simply pledge to retain all of their shares
until the good news emerges. Second, managers could purchase shares
directly from the corporation at the market price and retain those shares
along with the remainder of their shares until the good news emerges.
116 See Bhattacharya & Dittmar, supra note, at 4.
117 See Ikenberry & Vermaelen, supra note, at 9-10.
118 See Nikos Vafeas, Determinants of the Choice between Alternative Share Repurchase
Methods, 12 J. ACCT. AUDITING & FIN. 101, 112-13 (1997) (finding that following 156
OMRs from 1985 to 1991, mean and median insider percentage ownership dropped
from 15.7% to 15% and 8.7% to 7.7%, respectively).
119 One could argue that there might be an implicit commitment not to sell shares
in firms that have trading windows, which require managers to hold their shares for 3
months (or longer, if the next window doesn’t open). But even when trading windows
are closed managers often get permission to sell. See Carr, Bettis; Roulstone. Also,
abnormal returns following manager trades tend to last up to 12 months suggesting that
good news takes longer to emerge. Seyhun(?).
- 45 -
a. Simple Pledge to Retain Shares
Credible share-value signaling could be accomplished by managers
pledging to retain existing their shares until their private information
emerges.120
In short, there is no need to incur the administrative expense of a
repurchase (and perhaps distribute cash that is better invested in the firm) to
send a credible signal that the stock is underpriced.
To be sure, one could argue that if managers also pledged to conduct
a repurchase, they would send a ―stronger‖ signal that the stock is worth at
least the repurchase price. The signal would be even stronger because the
cost of false signaling would be higher. The managers would not only give
up the ability to sell their current shares for the current price; they would
also (indirectly) purchase additional shares at an inflated price. However,
repurchases target on average only 7% of a firm’s shares.121 A repurchase
therefore increases the cost to managers of false signaling by a relatively
small amount. It is highly unlikely that this additional cost would make the
difference between credible and non-credible signaling.122
The advantage of this mechanism is that if the managers wish to
signal – and we saw earlier that they generally won’t wish to signal in this
manner and never in fact do -- it does not require that the firm distribute
cash.
120 Returning to the preceding example, suppose that in January the market knows
that the value of ABC Corporation’s stock is either $5 or $15 per share and that by June
the market will know the correct value. Suppose that in January, when the stock is
trading at $10, managers learn that the actual value is $15. The managers could then
pledge to retain their shares until June. If the stock were in fact worth $5 per share, the
pledge to retain their shares would deprive managers of the ability to sell the stock for
$10 per share before the bad news emerges in June and it becomes clear that the stock is
worth only $5 per share. Thus, if the stock were worth $5 per share, the pledge to retain
their shares would impose a cost on the managers of $5 per share. If, on the other hand,
the stock were worth $15 per share, this pledge would not impose a cost on the
managers. Thus, the pledge to retain shares credibly signals that the stock is actually
worth $15, and after such pledge is made, the price should rise to $15.
121 See supra note.
122 One situation in which acquiring additional shares might be useful for signaling
is that in which the insider is anyways prevented from selling his shares – say, because
of a lock up agreement. In that situation a pledge to retain shares sends no information
about managers’ beliefs about the stock, but the indirect acquisition of shares through a
repurchase would provide such information. I thank Steve Choi for pointing this out to
me.
- 46 -
b. Managers Could Buy Stock from Firm at Market Price
To the extent one believes that a repurchase makes a more credible
signal than a pledge to retain shares because the repurchase forces the
managers retaining their shares to ―buy‖ their pro rata fraction of the shares
repurchased by the firm, one might not think that a pledge to retain shares is
an adequate substitute for a repurchase.
If so, the managers could buy the amount of shares that is equivalent
to the amount that they would indirectly buy through a repurchase. Thus if
the managers owned 100 shares, and they were to repurchase 7% of the
firm’s shares in the repurchase, they could simply buy 7 additional shares.
They could buy the shares directly from the firm or in the market.
Like the simple pledge to retain shares, this mechanism decouples the
payout from the signal, enabling managers to signal even when the firm’s
cash is better invested in the firm than distributed to shareholders.
C. Transaction Cost Savings
A third potential benefit of repurchases is that they might reduce
transaction costs borne by shareholders. In particular, if all shareholders
receive a dividend, those who are seeking liquidity (for consumption or
investment in other securities) will get what they want: cash. But those not
seeking liquidity will be forced to incur transaction costs reinvesting the
dividend in the stock of the issuing (or another) firm. With a repurchase,
those shareholders who do not seek liquidity can just sit still, incurring no
costs. Those who need cash sell the stock, which they might have needed to
do even had the firm issued a dividend.
As this Section explains, however, the transaction costs associated
with repurchases can be higher or lower than dividends, depending o the
parameters. And any transaction cost benefit achieved with repurchases
could easily be accomplished with dividends and dividend reinvestment
plans.
1. The Potential Benefit
If all shareholders receive a dividend, then those who are seeking
liquidity (for consumption or investment in other stock) will get what they
want: cash. But, in the absence of a dividend investment plan, those not
seeking liquidity will be forced to incur transaction costs reinvesting
dividend in the stock of the issuing firm. With a repurchase, those
shareholders who do not seek liquidity can just sit still, incurring no
- 47 -
transaction costs. Those who need cash can sell stock, which they would
need to do anyway (unless the dividend that would have been issued in
place of the repurchase would have provided them with sufficient cash).123
But any benefit provided by repurchases is likely to be small. First,
90% of share repurchases are conducted by firms that also issue dividends. 124
If dividends imposed meaningful transaction costs on these shareholders, the
shareholders would either (a) ask managers to convert the dividends into
repurchases or (b) sell their shares and buy the stock of firms not issuing
dividends.
Second, share repurchases are used to distribute transitory cash flows
and are done only once or twice every 5 years. These repurchases could be
replaced by large special dividends, which are very different from getting
the small dividends every quarter. Thus, even if some investors might prefer
repurchases over small quarterly dividends, those investors might not prefer
repurchases over a special dividend.
Third, large institutional investors, which own approximately 50% of
publicly traded shares, continually need cash for redemptions and operating
expenses and are thus likely not to be find dividends inconvenient.
2. The Potential Transaction Cost Disadvantage of Repurchases
Not only are the potential transaction cost benefits of repurchases
likely to be small, they might even impose net costs. First, repurchases
impose trading costs that dividends to not. In particular, shareholders
selling their shares must incur brokerage trading commissions are subject to
a bid-ask spread. For those shareholders who want cash, dividends would
therefore reduce transaction costs. Second, if the percentage of shareholders
seeking liquidity is high enough, a repurchase might well reduce transaction
costs, even putting aside the issue of brokerage commissions and the bid-ask
spread. Suppose, for example, that 60% of shareholders would like liquidity,
and that the special dividend the firm would issue in place of a repurchase
would satisfy their liquidity needs; the remaining 40% wish to increase their
investment in the firm. And suppose that every shareholder will receive the
special dividend. In that case, the special dividend would allow 60% of the
shareholders to get cash without selling their shares, and 40% would be
forced to take their dividend and reinvest in the firm’s shares. If there is a
share repurchase, 60% of the shareholders must sell shares, and only 40% can
sit still.
123 See Elton and Gruber, supra note x.
124 See Grullon and Michaely (2000), supra note x, at 7.
- 48 -
3. Dividend Reinvestment Plans Can Achieve the Same Benefit
Even if the transaction cost benefits of repurchases exceeded their
costs, dividends along with dividend reinvestment plans could achieve the
same benefit as repurchases. A dividend reinvestment investment plan
allows shareholders who would otherwise receive a dividend to be given an
equivalent amount of stock instead. These plans are generally used by
individual shareholders who wish to avoid the transaction costs associated
with reinvesting the small dividends they get quarterly. They are especially
popular among individual investors with relatively small shareholdings in
any given firm. To the extent that such shareholders also prefer repurchases
to special dividends they could use these plans for special dividends as well.
This would eliminate transaction costs for non-liquidity seeking
shareholders.
D. Funding Stock Option Plans
Some market observers have suggested that repurchases are necessary
to ―fund‖ employee stock option plans. These plans give employees options
to buy stock, exercisable against the firm when the options vest. Thus the
firm needs shares to satisfy these options. However, as I explain below,
there is no need for firms to buy stock on the open market to maintain their
employee stock option plans.
1. The Potential Benefit
Employee stock option plans have become increasingly popular. Most
of the top management’s compensation now comes in the form of stock.
Under these plans, employees are given options on the firm’s stock at a
certain strike price (usually equal to the market price on the date of grant).
The options cannot be exercised until the end of the vesting period. When
they are exercised, the firm must give the employees shares. The employees
will then typically sell their shares in the market.
A repurchase provides a benefit by allowing the firm to buy shares in
the market, over time, which they can use to ―fund‖ these option programs.
Indeed, there is some evidence of a connection between the use of
repurchases and these programs. In particular, the number of shares
repurchased by firms is correlated with the number of exercisable employee
options.125 And about 50% of repurchased shares are recycled through
125 See Kahle, supra note x, at 5. Weisbenner (2000) finds that total options
outstanding is correlated with repurchase activity (clarify); Kenneth J. Klassen and
- 49 -
option programs.126
2. The Dispensability of Repurchases
However, repurchases are not necessary for stock option plans. In
fact, a considerable number of firms maintain such plans without buying
back a commensurate amount of stock. They do this by issuing additional
shares. Alternatively, a firm that prefers not to issue additional shares can
employ share appreciation rights (SARs), phantom stock or other incentive
devices that do not require the use of actual shares.
VI. THE DESIRABILITY OF REPURCHASES WHEN STOCK DEMAND
CURVES SLOPE DOWNWARD
We have seen that, by coupling a redistribution to a dividend,
repurchases can create various distortions – including underinvestment,
cash-hoarding, and reduced disclosure. We have also seen that the benefits
commentators attribute to repurchases – financial flexibility, signaling,
funding option plans, and reduced transaction costs – can be achieved either
with dividends alone or with a much simpler and cheaper mechanism than
repurchases.
Throughout the discussion we have assumed implicitly (wherever it
was relevant) that the market price of the stock reflects everyone’s best
estimate of the value of the stock. Thus the only way that a repurchase could
affect the stock price is by affecting investors’ estimate of the value of the
stock, either through an efficiency effect or an informational effect. A
repurchase can affect this estimate in two ways. First, by changing the actual
value of the stock – for example, by distributing excess cash (the efficiency
effect). Second, when the public does not have complete information about
the value of the stock, by providing additional information to the market that
Ranjini Sivakumar, Stock Repurchases Associated with Stock Options do Represent Dollars out
of Shareholders’ Wallets (working paper, 2001)(finding that total options outstanding can
explain repurchase activity) Cf Jolls (1998) (finding no evidence that total options affect
likelihood of repurchase)(check).
126 Some economists have suggested that firms issuing stock to executives
exercising options are in effect engaging in a small equity offering. This decreases the
firm’s leverage. Thus, a repurchase can be used to increase the firm’s leverage back to its
desired level. See Grullon and Ikenberry (2000). However, as Part III.B. explained, a
repurchase has the same effect on leverage as a dividend that distributes the same
amount of cash. Thus, repurchases are not necessary to maintain the correct leverage
even if the firm is issuing stock to its executives.
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causes the market to change its estimate of the value of the stock (the
informational effect). For example, if managers are more likely to announce a
share repurchase when the stock is underpriced than when it is overpriced,
such an announcement will cause the market to revise upwards its estimate
of the value of the stock and bid the price up, even if it has no effect on the
underlying value of the stock.
We now consider another mechanism through which a repurchase
might be able to affect the stock price, even if only temporarily: by changing
the marginal shareholder. As I explain below, there is considerable evidence
that shareholders do not hold the same estimate of the value of a particular
stock. Some shareholders value it more than others. And at any given point
in time, the market price reflects what the marginal (lowest-valuing)
shareholder is willing to sell his shares for. Those shareholders who value
the stock higher will not sell at that price; those who value the stock will less
will have already sold their shares. The dispersion of values suggests that a
firm might be able to boost the price of its stock, at least temporarily, by
repurchasing shares from its lowest-valuing shareholders.
I want to make clear at the outset that I am not claiming that, as an
empirical matter, firms are able to permanently or even temporarily boost
the price of their stock simply by buying back their shares, even in the
absence of efficiency and informational effects described above. Rather, the
purpose of this Part is to describe the additional problems that are likely to
be associated with repurchases IF repurchases could boost the stock price
simply by reducing the number of shares. In doing so, I will consider two
possible cases: (1) that in which the repurchase can temporarily boost the
price of the stock until the market re-equilibrates (―temporary price
pressure‖); and (2) that in which the repurchase can permanently boost the
price of the stock (―permanent price pressure‖).
As I will explain, when repurchases can boost the stock price simply
by taking stock out of the hands of the lowest-valuing shareholders,
managers’ ability to conduct repurchases can lead to further distortions. In
particular, managers will have an incentive to use repurchases to boost the
stock price before selling their shares. This in turn will give rise to
distortions similar to those that arise when managers use repurchases to buy
stock at a low price. First, managers intending to sell shares might have an
incentive to repurchase shares to boost the stock price when from an
efficiency perspective the cash should be left in the corporation. Second, if a
repurchase cannot permanently boost the price of the stock by changing the
marginal shareholder, managers not intending to sell shares until some point
in the future might delay distributing cash that should otherwise be
distributed in order to provide them with cash to buy back shares from low-
valuing shareholders shortly before selling their own.
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The remainder of this Part proceeds as follows. Section A describes
the evidence suggesting that stock demand curves are temporarily or
permanently downward sloping and that repurchases can boost the stock
price, either temporarily or permanently. It also explains why stock demand
curves might be downward sloping. Section B describes the redistributional
effects of repurchases when they boost the stock price by changing the
marginal shareholder. Section C then describes the two distortions that can
result from the use of repurchases for this purpose.
A. The Possibility of Downward Sloping Stock Demand Curves
Until now the analysis has assumed that the stock price reflects the
market’s single shared estimate of the value of the stock. Thus, there is only
one way to affect the price of the stock – to change the market’s estimate of
its value. Accordingly, a repurchase could affect the stock price only either
by changing the value of the underlying stock – by, for example, improving
or worsening the leverage of the firm (an ―efficiency effect‖), or when the
market lacks all of the relevant information about the value of the stock, by
communicating information about that value to the market (whether or not
the repurchase changes the underlying value itself (an ―informational
effect‖). So, for example, if managers on average announce repurchases
when the stock is underpriced, then a repurchase announcement would
signal that, on an expected value basis, the value of the stock is higher than
was previously thought by the market. Importantly, I have assumed that
one cannot increase the price of the stock merely by buying shares. Put
differently, one could buy an unlimited number of shares without affecting
the stock price, as long as the repurchase has no informational or efficiency
effects. For quite some time, this has been the conventional view among
finance economists (and many law and economics commentators).127
However, over the last 10 to 15 years empirical studies have led many
economists to believe that one can affect the stock price, at least temporarily,
simply by buying or selling shares. 128 Under this view, at least in the short
127 See, e.g., Frank H. Easterbrook & Daniel R. Fischel, The Proper Role of a Target’s
Management in Responding to a Tender Offer, 94 HARV. L. REV. 1161, 1165-68 (1981).
128 For contributions to the empirical finance literature on the elasticity of supply
and demand for publicly traded shares, see generally Laurie Simon Bagwell, Shareholder
Heterogeneity: Evidence and Implications, 81 AM. ECON. REV. 218 (1991); Claudio Loderer et
al., The Price Elasticity of Demand for Common Stock, 46 J. FIN. 621 (1991). David T. Brown
& Michael D. Ryngaert, The Determinants of Tendering Rates in Interfirm and Self-Tender
Offers, 65 J. BUS. 529, 530 (1992); Lawrence Harris & Eitan Gurel, Price and Volume Effects
Associated with Changes in the S&P 500 List: New Evidence for he Existence of Price Pressures,
41 J. FIN. 815 (1986); Andrei Shleifer, Do Demand Curves for Stocks Slope Down?, 41 J. FIN.
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run, firms can drive up the price by repurchasing shares, even in the absence
of efficiency and informational effects.129
Buying or selling shares affects the stock price if the demand curve for
shares, like the demand curve for most other goods, is downward sloping.
At a lower price, more investors are willing to buy and hold stock. In order
to get investors to hold a certain number of shares, the price must be set
appropriately low. In order to get investors to hold more stock, the stock
must be offered at an even lower price. As the price rises, the shareholders
who value the stock the least will be induced to sell their shares. The higher
price that is offered, the more shareholders will sell their shares. Thus, to buy
an increasing amount of shares, one must offer a higher and higher price. In
other words, there is an upward-sloping supply curve for stock. Because our
interest is on the effect of repurchases on the effect of the stock price (rather
than the effect of secondary equity offerings), we will focus on the dynamics
of buying back shares from shareholders rather than selling additional shares
to shareholders, and thus refer to the upward sloping supply curve.
The price at which a seller is willing to sell a good is called his
―reservation value.‖ The market price (at which one can sell a share) is,
therefore, the reservation value of the lowest-valuing (or marginal)
shareholder. Shareholders with higher reservation values are not willing to
sell at the market price. Those with lower reservation values will already
have sold their shares.
There are a number of possible explanations for the dispersion of
reservation values among shareholders – or ―shareholder heterogeneity.‖
Shareholders may have different transaction costs or varying tax
579 (1986). For contributions to the theoretical literature, see Robert Jarrow,
Heterogeneous Expectations, Restrictions on Short Sales, and Equilibrium Asset Prices, 35 J.
FIN. 1105 (1980); Joram Mayshar, On Divergence of Opinion and Imperfections in Capital
Markets, 73 AM. ECON. REV. 114 (1983).
Some of the best evidence of the imperfect elasticity of shareholder supply
comes from shareholder tendering patterns in RTOs. In almost all fixed price RTOs,
some shareholders tender and some do not, indicating that many shareholders are
unwilling to sell even at what is usually a substantial premium over the pre-offer price.
See Comment and Jarrell, supra note, at 1257 (reporting an average tendering rate of 25
percent for 65 fixed price RTOs from 1984-89). And in Dutch auction RTOs,
shareholders typically tender along the entire price range, evidence that to purchase
more and more shares one must pay an increasingly higher price. See Bagwell, supra
note __, at 72.
129 For a long time this has also been accepted wisdom in the markets, not only in
the US but also abroad. See Business Recorder, 2001 WL 3348266 (2/4/2001) (reporting
that Toyota sought permission to buy back a large number of shares in order to reduce
the supply and thereby boost the stock price).
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situations.130 Shareholders may have asymmetric information about the value
of the stock. Finally, shareholders may have the same information about a
stock but nevertheless form heterogeneous expectations about its future
performance.131 Whatever the source(s) of shareholder heterogeneity, the
important point is that the shareholder supply curve slopes upwards.
Given an upward-sloping supply curve, a firm repurchasing its shares
takes those shares out of the hands with those whose reservation values are
at or below the repurchase price, leaving shares in the hands of those whose
reservation values are higher. The shareholders remaining after the
repurchase will, therefore, tend to have higher reservation values than the
pre-repurchase shareholders.132 Most importantly, the post-repurchase
marginal shareholder -- the shareholder with the lowest reservation value
after the repurchase -- should have a higher reservation value than that of
the pre-repurchase marginal shareholder. 133 Everything else equal, a
repurchase could increase the trading price of the stock through this ―price
pressure‖ effect. 134
To be sure, a repurchase is not identical to a third party purchasing
the firm’s shares. When a third party purchases a share from a current
shareholder, the firm itself is unaffected, and the intrinsic value of the share
is unaffected. Thus the purchase should not affect shareholders’ reservation
values. But when the firm repurchases its own shares, both the value of the
firm and the value of each remaining share change: the firm reduces its value
by paying cash for its own stock and each remaining share now has a claim
to a larger fraction of the that lower value. Thus, the repurchase itself could
affect shareholders’ reservation values during the repurchase by changing
the underlying value of each share. However, I will assume for purposes of
130 See Lakonishok and Vermaelen, supra note, at 459; Gay, Kale, and Noe, supra
note, at 63-66. There is evidence that differences in public shareholders’ tax costs from
tendering make tendering on an after-tax basis worthwhile for some shareholders but
not for others. See Brown and Ryngaert, supra note, at 530.
131 See Stout, supra note x, at ________; Booth, supra note x, at _____. One might
think that the shareholder with the highest reservation value would buy out all of the
shareholders with lower reservation values at a mutually agreeable price. However,
because of risk aversion, liquidity constraints, transaction costs and taxes, a
shareholder’s selling reservation value is likely to be higher than his buying reservation
value. See Brown and Ryngaert, supra note, at 529 (examining determinants of
shareholder reservation values); Stout, supra note x, at _____. See Gerald D. Gay, Jayant
R.Kale, and Thomas H. Noe, Share Repurchase Mechanisms: A Comparative Analysis of
Efficacy, Shareholder Wealth, and Corporate Control Effects, Fin. Mgmt. 44,46 n.9 (1991).
132 See Booth, supra note x, at 1089 (observing that open market share repurchases
put upward pressure on the price by eliminating the lowest-valuing shareholders).
133 Cf. Bagwell, supra note, at 72-73 (describing evidence that Dutch auction RTOs
change the marginal shareholder).
134 See Dittmar, supra note, at 335.
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this Part that even after such an adjustment shareholders’ reservation values
continue to be dispersed in a way that permits the firm to boost the stock
price by repurchasing shares . This is likely to be the case at least until the
market learns that the firm has been buying its own shares, which might take
months or even a year from the time the repurchase begins.
B. Managers’ Use of Repurchases to Sell at a Higher Price
We saw in Part IV.A. that managers can -- and do -- use the
redistributional effect of repurchases to transfer value to themselves and
remaining shareholders by repurchasing shares when the actual value of the
stock exceeds the stock price. Because market participants are not unaware
of this fact, market participants are likely to infer from a repurchase
announcement that the stock may be underpriced, and bid up the price of the
stock upon hearing a repurchase announcement. 135 This, in turn, suggests
that managers intending to sell shares might announce a repurchase in order
to boost the price of the stock before selling the shares, even if they have no
immediate intention of repurchasing any shares.
We now turn to consider how upward sloping supply curves for stock
might provide another means by which managers can transfer value to
themselves from public shareholders. If supply curves for stock slope
upwards, then managers intending to sell shares can use repurchases
themselves to boost the market price of the stock, at least temporarily, before
selling their shares. Thus by announcing a repurchase and then actually
repurchasing shares, managers can boost the stock price not only by
implicitly signaling that the stock is underpriced but also by buying shares
from the lowest-valuing shareholders.
As also noted in Part IV.A., an important limit on managers being able
to use repurchase announcements to boost the stock price is that, for various
reasons, managers cannot announce a repurchase every time they wish to
sell stock. For example, managers cannot announce a new repurchase until
they have completed the previous repurchase program, which might take
months or even years. But to the extent the firm has cash that can be used for
buying back stock, managers can always repurchase stock shortly before
selling their shares. Thus, upward sloping supply curves would increase not
only the magnitude of the price boost that managers can achieve using
repurchases and repurchase announcements but also the frequency with
135 As noted above, there are other reasons that market participants might react
favorably to a repurchase announcement besides the signal it sends about the actual
value of the stock. For example, investors might bid the price up because they believe
the firm will distribute excess cash that it had been holding and that was earning poor
returns.
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which repurchases can be used to boost the stock price before selling.
As noted in Part IV.A, managers are frequent sellers of shares. Most
managers receive a substantial portion of their salary in the form of stock
options that give them the right to purchase the corporation’s shares at a
discounted price. Although managers may decide to hold the purchased
shares in their portfolios, they will frequently sell the stock acquired by
exercising the options. 136
Managers sell shares for a number of different reasons. They may
wish to diversify their holdings. They may have liquidity needs. Or the
managers may know ―bad news‖ and wish to sell before that news emerges
and drags down the stock price. 137 Regardless of the reason, once the
managers have decided to sell shares, they will wish to sell those shares at
the highest possible price. And managers thus have an incentive to use
repurchases to buy back shares from the lowest-valuing shareholders and
thereby boost the stock price before selling their own shares.
It should be noted that managers, to the extent that they continue to
own shares in the firm, have an incentive not to reduce the value of those
shares by buying stock that is overpriced. Thus in deciding whether to
repurchase shares to boost the stock price, they will take into account not
only their ability to boost the stock price but also the effect of the repurchase
on their remaining shares. If managers are selling most of their shares
however, then the actual value of the shares being repurchased is not as
relevant.
We saw earlier that there is evidence consistent with the use of
repurchase announcements to boost the stock price before managers sell
shares: at least one study reports that mean and median insider percentage
ownership fall around the time the repurchase is announced. Because firms
generally do not report when they actually repurchase shares, there is no
similar study examining the relationship between insider ownership (or
sales) and actual repurchases. However, to the extent that there is a
correlation between repurchase announcements and repurchases, this
evidence is also consistent with the use of repurchases themselves to boost
the stock price before managers sell their shares.
136 In fact, managers of publicly traded corporations sell approximately twice as
much of their own corporation’s stock as they buy. ________Seyhun, supra note x, at
194; _________Rozeff and Zaman, supra note x, at 42. See H. Nejat Seyhun, The
Effectiveness of Insider Trading Sanctions, 35 J.L. & Econ. 147, 158-60 (1992).
137 For an explanation of the limited effect insider trading laws have on managers’
ability to trade on inside information, see supra Part IV.A.1.b. For a summary of
empirical studies finding that managers sell before the release of bad news, see Fried,
supra note, at 317-20.
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C. Potential Distortions
Having seen the distributional effects of the price pressure induced by
a repurchase, it is now time to consider the additional distortions that can
arise if a repurchase can be used to generate such price pressure. We first
examine managers incentive to use price pressure to boost the stock price.
We then examine the two distortions that can result from the use of price
pressure to boost the stock price: (1) underinvestment and (2) cash hoarding.
1. Underinvestment
[TBA]
2. Cash-Hoarding
Managers might have an incentive to use repurchases to delay
distributing cash through a repurchase until shortly before they plan to sell
their shares. Note that managers might have an incentive to delay
distribution even if a repurchase generates a permanent price pressure effect
because, to the extent that they will be given options during the intervening
period, which are usually set to the grant-date market price, they wish to
keep the price low. Indeed, there is evidence that managers manipulate the
release of news by accelerating the release of bad news and delaying the
release of good news to lower price around the time they are granted.
VII. INFERRING THE DESIRABILITY OF REPURCHASES FROM THE WORLD
AROUND US
Part IV identified several potential efficiency costs associated with the
use of repurchases – underinvestment, cash-hoarding, and reduced
disclosure. In Part V we examined various benefits of a repurchase and saw
that they could easily be replicated by a dividend or another, simpler
mechanism.
In this Part, I want to consider whether there is any empirical
evidence that, notwithstanding the analysis in Parts IV and V, share
repurchases are desirable. Section A considers two empirical regularities
that might suggest that repurchases are desirable (1) that share repurchase
announcements tend to boost the stock price; and (2) that firms fail to
prohibit repurchases in their charters – which might be expected if
repurchases were undesirable. Section B considers empirical evidence
suggesting that repurchases are an inferior method of distributing cash – the
fact that many firms continue to use dividends notwithstanding their tax
disadvantages.
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A. Is there Evidence in Favor of Repurchases?
1. The Stock Price Reaction to Repurchase Announcements
As noted in Part II, the market reacts positively (on average) to OMR
announcement. The market reaction is strongest if the announcement is the
first in 5 years: _____, and gets progressively weaker each successive
announcement_________. One might infer from the favorable stock market
reach to repurchases that repurchases are socially desirable. But this
inference is not warranted.
First, I will show that the market price could increase even if the
repurchase signaled by the announcement is expected to destroy value ex
post, say, by distributing needed cash. Second, to the extent some of the
harms of a repurchase occur ex ante, such as cash-hoarding (under-payout of
cash), these harms will not be reflected in the stock price reaction to
repurchase announcements ex post. Thus even if the stock price
announcement signaled that the repurchase is expected to be value-creating
ex post, one could not conclude that the anticipated repurchase is overall
value-creating. Third, even if (a) repurchases created value ex post and (b)
did not destroy value ex ante, the positive stock market reaction to their
announcement would still not establish their desirability because the
alternative to the repurchase is not necessarily retaining the cash but rather
distributing it as a special dividend.
a. Price-boosting repurchase can destroy value ex post
I will now explain why one cannot infer that a repurchase is value-
creating ex post simply because its announcement causes the stock price to
rise or because the stock price rises after the firm actually repurchases shares.
The reason that the stock price reaction to a repurchase announcement
or to the repurchase itself cannot be used to infer the ex post efficiency effects
of the repurchase is that the stock price increase could result in large part
from factors that have nothing to do with the ex post efficiency of the
repurchase.
Recall that a repurchase can affect ex post value in two ways: (1) by
moving capital from corporate investments to projects outside the
corporation and (2) by altering leverage. If the stock price reaction reflected
only these two effects, and the stock price reaction were positive, we could
infer that repurchases tend to be value-creating ex post.
But the stock price rise could be generated by factors that have
nothing to do with value creation: (1) expropriation of value from creditors;
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(2) signaling effects, or (3) in the presence of downward sloping demand
curves for stock, price pressure.
1. Expropriation of Creditors
Until now the analysis has assumed for simplicity that a repurchase
affects only shareholders – and thus that a repurchase’s effect on shareholder
value is the same as its effect on social value. However, in examining the
stock market’s reaction to repurchase announcements we must take into
account the possibility that – in the real world – a repurchase does affect the
value available to parties other than the shareholders.
In the real world, a repurchase can affect the firm’s creditors. In
particular, a repurchase, like a dividend of the same amount, can transfer
value from creditors to shareholders. Any distribution of cash by the
corporation might transfer value from creditors to shareholders by (a)
reducing the amount of assets that are available to pay their claims in the
event of default; and (b) increasing the amount of cash that will have been
received by shareholders should the firm later fail.138
To be sure, if the likelihood of default is zero after the cash
distribution, then a distribution does not transfer any value. The money
would have gone to the shareholders in any event. However, even the most
stable firms have a nonzero probability of default. In fact, there is evidence
that on average both repurchases and dividends do transfer value from
creditors to shareholders.139
To the extent a repurchase is expected to transfer value from creditors
to shareholders, its announcement will increase the expected cash flow to
equityholders and therefore boost the stock price. Thus, part of the market’s
positive reaction to repurchases could be due to the expected transfer of
value from creditors to equityholders. This transfer, and the stock price
generated in expectation of this transfer, do not reflect the creation of social
value, but rather the shifting of value from one set of claimants on the firm’s
cash flow to another. To the extent the stock price increase reflects this
expected transfer of value, the market’s reaction to the repurchase
announcement does not signal that the repurchase is ex post efficient.
138 A repurchase/dividend can also hurt creditors by increasing the probability of
financial distress and failure to the extent that it reduces the cash reserves of the firm.
This, of course, provides no offsetting benefit to shareholders.
139 See e.g., William F. Maxwell and Clifford P. Stephens, The Wealth Effects of
Repurchases on Bondholders (working paper, 2001) (finding evidence of wealth
transfer); Upinder Dhillion and Herb Johnson, The Effect of Dividend Changes on Stock
and Bond Prices, 49 J. Fin. 281 (1994)(finding evidence that large dividends transfer
wealth).
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In fact, the announcement might boost the stock price even if
shareholders expect the repurchase to reduce total value by, for example,
distributing cash that would earn a higher return for the corporation.
Suppose, for example, that in expectation the repurchase that is announced
will destroy $1 of value per share, but at the same time transfer $3 per share
from creditors to equityholders, so that equityholders expect to gain $2 per
share. Equityholders would react to the announcement of such a repurchase
by bidding up the price of the stock, even though the total amount of value
available will, in expectation, decrease as a result.
2. Incidental Signaling
A second reason why stock pre announcements might boost the stock
price even if the repurchase itself is not expected to increase social value or
even increase the value available to shareholders value is that the repurchase
announcement signals that the stock is likely to be underpriced. For now,
suppose that repurchases do not have any efficiency effects or transfer value
from creditors. Repurchase announcements could still boost the stock price
to the extent they reveal that expected share value exceeds the stock price
(that is, they reveal the stock is likely to be underpriced). Repurchase
announcement would communicate that expected firm value exceeds the
stock price if managers are more likely to announce a repurchase when the
stock is underpriced than when it is overpriced (or, on average the stock of
firms announcing repurchases is underpriced).
In fact, managers are more likely to announce a repurchase when the
stock is underpriced. We have seen that managers can use repurchases for
the following two purposes: (1) to indirectly buy stock at a low price for
themselves and remaining shareholders (―indirect buying firms‖); and (2) to
boost the stock price before selling their shares (―selling firms‖).
If all repurchase announcements were motivated by indirect buying
firms and selling firms, and there are equal numbers of both, we would
expect the firms making such announcements to be, on average,
underpriced. Take selling firms. There are three reasons why mangers
might sell: for liquidity reasons, to diversify, or to sell before news comes
out revealing that the stock is underpriced. In those firms where managers
wish to sell for liquidity or diversification reasons, the stock might be
underpriced. Thus sometimes the stock of firms announcing repurchases to
boost the price of the stock will be underpriced, and sometimes it will be
overpriced. In contrast, all of the repurchase announcements by indirect
buying managers will be made by firms whose stock is underpriced. Thus if
the pool of announcing firms is composed equally of indirect buying and
selling firms, there will be more underpriced firms than overpriced firms and
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on average these firms are likely to be underpriced.140
In addition, there are likely to be more indirect buying firms than
selling firms. Managers can profit from indirect buying simply by retaining
their shares—that is, without any buying or selling. In contrast, selling firm
managers must be able to sell their shares. And while there are no
constraints on managers’ ability to retain their shares, there are constraints
on managers’ ability to sell their shares. For example, firm-imposed
restrictions on managerial trading might prevent a manager from selling her
shares except during several short ―trading-windows‖ throughout the
year;141 the manager might have a large built-in gain on which she wishes to
avoid paying capital gains tax; or the manager might have purchased shares
at a lower price within the previous six months and thus would face section
16(b) liability were she now to sell her shares. Because there are constraints
on managers selling but no constraints on retaining their shares, there are
likely to be more indirect buying than selling repurchases and this would
cause the pool of announcing firms to be even more underpiced. Thus, a
repurchase announcement is likely to signal that the stock is, in expectation,
underpriced.
To the extent a repurchase announcement signals that the actual value
of the stock is likely to be higher than the pre-announcement market price,
its announcement will cause investors to revise upwards their estimates of
the value of the shares and bid up the stock price. Thus, part of the
market’s positive reaction to repurchases could be due to this ―incidental
signaling‖ effect. The stock price increase due to this signaling effect does
not reflect the creation of social value. Thus, to the extent the stock price
increase reflects this informational effect, the market’s reaction to the
repurchase announcement does not signal that the repurchase is ex post
efficient.
In fact, as with the expropriation of value from creditors, the
announcement might boost the stock price even if shareholders expect the
repurchase to reduce total value by, for example, distributing cash that
would earn a higher return in the corporation. Suppose, for example, that
the repurchase that is announced is expected to destroy $1 of value per share,
but at the same time signals that, everything else equal, the stock is $3 per
share more valuable than was previously thought. In that case,
140 And it is useful for incidental signaling – managers buy low and use
repurchases to diversify, get liquidity, or sell high – so on average the stock is
underpriced. See Grullon and Ikenberry p.38. [They note that the Canadian data is very
similar to the US]
141 See Bettis et al., supra note, at 192.
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equityholders would revise upward their estimate of the value of the stock
by $2 per share. Equityholders would react to the announcement of such a
repurchase by bidding up the price of the stock, even though the total
amount of value available will decrease as a result.
3. Price Pressure
Even if a repurchase announcement could not boost the stock price by
signaling a transfer of value from creditors or incidentally signaling that the
stock is likely to be underpriced, the announcement might still be able to
boost the stock price by signaling that there will be a change in the marginal
shareholder. As we saw in Part VI, when stock demand curves are
downward sloping, a repurchase changes the identity of the marginal
shareholder. Thus to the extent that shareholders’ reservation values for the
stock are dispersed, the firm can eliminate lower-valuing shareholders by
buying back stock, and thereby boost the market price. If investors
anticipate that an announced repurchase will change the marginal
shareholder and thereby boost the stock price, they might bid up the price of
the stock in anticipation, changing the marginal shareholder immediately.
Thus, part of the market’s positive reaction to repurchases could be due to
this anticipated price pressure effect. The stock price increase due to
anticipated price pressure, just like those parts due to value-transfer from
creditors and incidental signaling, does not reflect the creation of social
value. Thus, as with these other factors, to the extent the stock price increase
reflects this expected price pressure effect, the market’s reaction to the
repurchase announcement does not signal that the repurchase is ex post
efficient.
As with the value-transfer and signaling effects, the price pressure
effect might cause the announcement to boost the stock price even if
shareholders expect the repurchase to reduce total value by, for example,
distributing cash that would earn a higher return for the corporation.
Suppose, for example, that the repurchase that is announced is expected to
destroy $1 of value per share, but at the same time replaces the old marginal
shareholder with a new marginal shareholder who, everything else equal,
would value the stock at $3 more per share. In that case, investors would bid
up the price of the stock by $2 per share, even though the total amount of
value available will decrease as a result of the repurchase that is expected
following the announcement.
b. Ex Ante Harms
Even if the positive stock price reaction to repurchase announcements
did not reflect a transfer of value from creditors, incidental signaling, or price
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pressure, but rather the ex post creation of value, one still couldn’t conclude
that repurchases are socially desirable. The reason is that there are ex ante
(pre-announcement and pre-repurchase) effects of using repurchases to
distribute value, and these effects will not be reflected in the stock price
reaction to the repurchase announcement. Importantly, there could be a large
number of ex ante costs to the use of repurchases. As Part IV.B. explained, to
managers might inefficiently retain funds while waiting for the stock price to
fall below its actual value. The resulting loss of value will not be reflected in
the market’s reaction to the subsequent repurchase announcement. Indeed,
the greater is the inefficiency cost from the cash hoarding, the greater is the
benefit to shareholders from distributing the cash, and the larger the
market’s reaction will be. Thus paradoxically, a large stock price reaction
could mean a large ex ante inefficiency.
If the net ex ante cost of using repurchases to distribute cash exceed
the net ex post benefits, then the stock market will react positively to a
repurchase even when, taking into account both ex ante and ex post effects,
the use of the repurchase to distribute cash destroys value. This is yet
another reason why one cannot conclude from the market’s positive reaction
to repurchase announcements that repurchases are desirable.
C. Comparison with Dividends
Even if the stock price reaction to share repurchases reflected the
creation of value ex post (and not value-transfer, signaling, or price pressure)
and there were no ex ante costs to the use of repurchases, one still could not
conclude from the market’s positive reaction to repurchase announcements
that repurchases were as desirable as dividends without comparing the
efficiency benefits to those of dividends. Interestingly, the stock market’s
reaction to dividend announcements is greater even though they are less tax
efficient142 (although this might be due to the strong signaling effect of
dividends because they imply an ability and commitment to continue paying
dividends indefinitely).
142 There is evidence that the relative tax efficiency of repurchases accounts for
some of the positive response to their announcement. See Clifford Stephens, Open-market
repurchase programs and the effects of the capital gains tax preference (working paper, 1998)
(reporting that abnormal returns observed around the announcement of OMRs declined
as a result of the decrease in overall tax rates and the capital gains tax preference);
Grullon and Michaely (2001), supra note x, at 5 (reporting that the market reaction to
OMR announcements was higher before the 1986 TRA which reduced the differential
between ordinary and capital gainst tax rates)
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2. What can be Inferred from the Failure of Corporate Charters to
Prohibit Repurchases?
As we have seen in Parts IV-VII, repurchases are likely to be a less
efficient means of distributing cash than dividends. But if share repurchases
are inefficient, then one might argue assume that investors should be willing
to pay more for shares of firms whose charters prohibit repurchases. The
failure of firms to prohibit repurchases in their charters may thus seem to
demonstrate that repurchases are efficient.143
However, even if managers’ ability to conduct share repurchases is on
balance undesirable for society, it might not be undesirable for shareholders.
In fact, it may well be beneficial to shareholders. To be sure, if share
repurchases are on balance inefficient, shareholders would fully bear the
expected efficiency costs, either directly or indirectly. To the extent the use
of repurchases inefficiently reduced the expected cash flows for equity, these
costs would hurt shareholders directly. To the extent the repurchase
reduced the cash flow to debt, these costs would be borne by the
shareholders through higher interest rates.144
However, as I explained in Part II, repurchases are a much more tax
efficient mechanism than dividends for distributing cash. If this tax benefit to
existing shareholders outweighs the net efficiency costs of share repurchases,
then shareholders would pay a higher price for the shares of corporations
whose charters do not prohibit repurchases.
It should be emphasized that this tax benefit to shareholders does not
increase total value but rather merely transfers value from other parties to
themselves (or, prevents the transfer of value from themselves to other
parties) and leaves the size of the pie unchanged. The tax savings of
repurchases comes at the expense of others who would have received the tax
proceeds or paid less in taxes had the distribution been made as a dividend.
In addition, if demand curves for stock are downward sloping, and
firms can use repurchases to boost the price of their shares by eliminating the
lowest-valuing shareholders, it will be in the interest of shareholders to give
143 For purposes of analyzing the inference that can be drawn from the failure of
corporate charters to prohibit repurchases, I assume that the price paid for shares at an
IPO reflects the contents of the corporate charter. If this is not the case with respect to
restrictions on share repurchases, one clearly could not infer from the absence of such
restrictions in charters that managers= unrestricted ability to conduct share repurchases
is desirable.
144 Except involuntary creditors.
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managers the ability to repurchase shares. The reason is that, to the extent
repurchases boost the stock price by altering the marginal shareholder, the
managers can use repurchases to transfer value from buyers to those current
shareholders buying their shares. Although a full analysis of the
distributional effects of repurchases under downward sloping demand
curves is beyond the scope of this project, it can be shown that if managers
repurchase shares only when the actual value of the shares exceeds the
repurchase price, the price-pressure effect of repurchases will
unambiguously transfer value from buying shareholders to selling
shareholders and other remaining current shareholders.
Note that while it might be in the interest of the initial shareholders of
Firm A to permit Firm A’s managers to engage in repurchases in order to
exert price pressure, these shareholders might end up paying more for the
stock of Firm B because of Firm B’s managers’ ability to use price pressure to
boost the price of the stock, and vice versa. Thus investors as a group are
unlikely to benefit from the ability of managers of each firm to exert price
pressure through repurchases.
In sum, because of the tax externality and a potential price pressure
externality, one cannot infer from the absence of restrictions on repurchases
in corporate charters that repurchases are, on balance, efficient.
B. What Does the Use of Dividends tell us?
We have seen that the stock market’s positive reaction to share
repurchase announcements and the failure of firms to prohibit repurchases
in their charters does not provide evidence that managers’ ability to conduct
repurchases is desirable. We now turn to evidence that the use of
repurchases to distribute cash to shareholders might be undesirable – the
continued use of dividends to distribute cash even though dividends are tax-
inefficient.
Although the use of share repurchases to distribute cash has grown
substantially over the last twenty years, approximately 50% of the cash
distributed by US corporations is still distributed by dividends. The failure
of firms to switch entirely to share repurchases suggests that,
notwithstanding their tax inefficiency, there are many shareholders that
prefer having cash distributed through dividends rather than repurchases.
One possible reason for the continued use of dividends is that firms
are reluctant to cut dividends and replace them share repurchases, because a
dividend cut will be taken as a signal that the firm’s managers no longer
believe the firm will have the necessary cash flow to finance the dividends it
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had been paying.145 But there is evidence that on average firms cutting
dividends don’t experience abnormal price drops if they have also been
repurchasing their shares.146 In other words, investors appear to believe that
these dividend cuts do not reflect new information about the firm’s expected
cash flow but rather represent managers’ substitution of a more tax efficient
(although perhaps overall less efficient) distribution mechanism for one that
is less efficient. In addition, 20% of firms initiating distributions start by
issuing dividends rather than by repurchasing shares. These firms were not
required to issue dividends to avoid sending a bad signal. 147
One possibility is that much of the demand for dividends comes from
tax-exempt investors (such as pension funds).148 But even if this is the case, it
shows that when taxes are irrelevant, investors prefer dividends.
VII. A NEW APPROACH TO THE REGULATION OF REPURCHASES
This Part proposes and puts forward a change to the regulation of
repurchases that is designed to minimize the efficiency costs that are
uniquely associated with them. Before proceeding, it should be emphasized
that the proposed change would not in any way reduce or undermine the
potential benefits of share repurchases. Thus, even if the benefits attributed
to repurchases – financial flexibility, signaling, funding option plans,
reduced transaction costs – could not easily be replicated (which in fact they
can be), those benefits would not provide a reason for rejecting the proposed
reform.
A. The Proposed Approach: Pre-Repurchase Disclosure
In earlier work I have shown that requiring insiders to disclose their
intended trades in advance would substantially reduce insiders= ability to
engage in insider trading. The reconceptualization offered in this paper
shows that a repurchase is distributionally equivalent to remaining
shareholders purchasing the shares of departing shareholders. The
reconceptualization thus suggests that requiring firms disclose in advance
every intended trade would also reduce managers= ability to indirectly trade
145 DeAngelo et al. Dividends and Losses, 47 J. Fin. 1837, 1862 (1997).
146 See Grullon and Michaely.
147 Admittedly, however, they might have chosen to begin issuing dividends in
order to send a signal that the managers expect future cash flows to be healthy, and
thereby sharply boost the price of the stock (perhaps before selling their shares).
148 See Allen, Bernardo, and Welch.
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on inside information. 149
Under the pre-repurchase disclosure rule, a corporation could not
submit an order to its broker to buy its own shares without first giving notice
to the market of the order at least several hours (and perhaps as much as one
business day) in advance. So for example, if the order to the broker is ―buy
1000 shares at $10 or below,‖ the corporation would need to disclose that it
was submitting an order to the broker to buy 1000 shares at $10 or below. . In
the disclosure, the corporation could include any other information that it
wishes to communicate to the market. So, for example, if the firm knew that
it would not be buying more than 5000 shares over the next month, it could
choose to disclose that information as well. The disclosure would be made by
filing details of the order on the SEC's Electronic Data Gathering And
Retrieval system ("EDGAR"), which can make the information available to
the market upon its arrival at the SEC. The firm would then be required to
report the details of the purchase within a few days.
Following the disclosure of an intended repurchase, market
participants could adjust the price at which they are willing to trade to reflect
the heightened possibility of an abnormal price change that is signaled by the
corporation’s order. To see how the rule might work, consider the following
example. Suppose that on Monday, when ABC stock is trading for $10, the
firm announces that, on Tuesday, it will submit an order to buy 20,000 shares
at a price of $11 or lower. Knowing that there is a possibility that the
corporation is buying now because the managers believe, based on inside
information, that the stock is underpriced, market participants who had been
considering trading ABC stock on Tuesday and Wednesday might choose to
modify or abandon their planned trades. Market participants who were
149 An alternative to pre-purchase disclosure would be to require firms
repurchasing shares to adhere to the guidelines set out in Rule 10b5-1 that are designed
to give insiders an affirmative defense to insider trading liability under Rule 10b-5.
Under Rule 10b5-1, there are two such safe harbors that would apply to firms
repurchasing shares. Under the first, the firm would ―specify with precision the
amounts, prices, and dates on which it will repurchase its securities‖, or it may ―use a
written formula to derive amounts, prices, and dates,‖ or it may ―simply delegate all the
discretion to determine amounts, prices, and dates to another person who is not aware
of the material nonpublic information.‖
Under the second, the firm could show that the individual making the decision
to repurchase the shares was not aware of the information and that the firm had
implemented reasonable policies and procedures to ensure that individuals making
such decisions did not violate the laws trading on the basis of material inside
information. See Steven E. Bochner and Leslie A. Hakala, Implementing Rule 10b5-1 Stock
Trading Plans, 15 INSIGHTS 2 (2001)
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considering selling shares of ABC stock might not go forward with these
sales, or might increase the price at which they are willing to sell the stock.
Market participants who were considering buying ABC stock might increase
the price at which they are willing to buy it. Market participants who, prior
to the firm's announcement, were not considering buying the stock might
decide to buy shares. The combined effect of these adjustments would be,
everything else being equal, to increase the price at which those making a
market in the stock are willing to buy and sell the stock. When the firm’s
repurchases are executed on Wednesday, it is likely to be executed at a
higher price than if the firm had not disclosed the order in advance--to the
extent that market participants believe that the managers are trading on
inside information.
The prerepurchase disclosure requirement would not be difficult to
enforce. The SEC could easily maintain a record of the prerepurchase
announcements that it receives. Reported repurchases and announcements
could be matched to determine whether any trades had not been preceded
by an announcement.
B. The Benefits of Pre-Repurchase Disclosure
Pre-repurchase disclosure would make it more difficult for managers
to use share repurchases to transfer value from selling shareholders. To the
extent that investors believed that the announced repurchase was intended
to buy stock for remaining shareholders at a low price, the announcement
would cause them to bid up the price of the stock, reducing the value that is
transferred to remaining shareholders. This in turn would reduce managers’
incentives to use repurchases to transfer value in the first instance, which
would also reduce the accompanying distortions – underinvestment, cash-
hoarding, and reduced disclosure.
A potential problem with pre-repurchase disclosure is that managers
might use the disclosure to boost the stock price before selling their stock,
even when the stock is overpriced. To be sure, the managers would then be
forced to indirectly acquire shares at a high price, but they would need to sell
very few of their own shares to give them a net gain. Suppose that the firm
buys back 1000 shares at an inflated price and managers own 5% of the
company. This is equivalent to the managers buying 50 high price shares. As
long as the managers sell more than 50 shares at that same price, they will
profit from the transaction. This problem could be overcome by requiring
managers themselves to announce their trades in advance. Such advance
disclosure would reveal to the market the net direction of managers’ direct
and indirect trades, allowing the market to draw the appropriate conclusion
about the actual value of the stock.
To the extent that demand curves for stock slope downward, the
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ability of pre-repurchase disclosure to reduce the resulting distortions is less
certain. If firms can permanently boost the stock price by buying back shares,
pre-repurchase disclosure is unlikely to have much effect. However, if
buying back shares creates only temporary price pressure, then pre-
repurchase disclosure might reduce managers’ ability to use repurchases to
boost the price shortly before selling their shares. If price pressure is only
temporary, this suggests that there are sellers interested in selling their
shares for slightly higher than the current, but it takes them some time to
place their orders. In the meantime, the price remains elevated. Advance
notice of the firm’s intent to repurchase stock might bring those sellers into
the market more quickly, and thereby reduce the period of time in which the
stock price is temporarily elevated.
C. The Costs of Pre-Repurchase Disclosure
[TBA]
1. Financial flexibility
2. Signaling
3. Transaction costs
4. Stock options plan funding
D. Implications for Dividend Taxation and Option Accounting Rules
1. Reduce Tax Subsidy For Repurchases
The analysis of the paper suggests that there is no corporate
governance reason why the tax system should implicitly subsidize
repurchases, and that such a subsidy could in fact give rise to a substantial
cost. Thus an important tax policy implication of this paper is that it would
be desirable, everything else equal, to reduce this subsidy. Although the
question of the optimal tax rate on investment is a complex one that is
beyond the scope of the paper, an implication of the analysis is that no
matter what the rate is, the rate should be the same for dividends as for
repurchases. There are two possible approaches to closing the tax gap
between dividends and repurchases. The first is to tax dividends more like
repurchases. The second is to tax repurchases more like dividends. Below I
consider both types of approaches – including the possibility of eliminating
taxes on both repurchases and dividends.
Completely eliminating the tax distortion in favor of repurchases
would require moving to a consumption tax. However, one could reduce the
distortion either by treating share repurchases more like dividends or vice
versa. For example, one could use the reconceptualization of a share
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repurchase put forward in the paper to tax share repurchases according to
their economic substance. Under such a scheme, the selling shareholders
would (as under current law) pay a capital gains tax on the sale of their
shares; the remaining shareholders would be taxed as if they had received a
dividend and their basis in their shares would be increased by the amount of
the dividend. The problem with this approach is that it might get very
complicated, since the composition of shareholders is changing daily and
repurchases occur daily. You would need to attribute dividends to the
correct shareholders.
Alternatively, one could tax dividends at the capital gains rate, and
tax shareholders on dividends only to the extent the dividend exceeds their
adjusted basis in the stock.
2. Accounting: End Discrimination Against Dividend-Protected Options
To the extent that the use of repurchases is driven by an accounting
system that treats options in a way that discriminates against dividends, a
second implication of this paper’s analysis is that it would be desirable to
end such discrimination. The appropriate accounting treatment of employee
options has been a subject of much debate and I have no intention of entering
that debate here. However, if, as it appears likely, the accounting treatment
of options is to be overhauled, a second implication of the paper is that it
should be done in such a way as to level the playing field between dividends
and repurchases.
The accounting bias in favor of dividends that arises in firms using
option compensation could be eliminated either by requiring all firms
granting stock options to managers to record them as an expense, whether or
not they are dividend-protected, or by not requiring firms granting
dividend-protected stock options to record them as an expense.
VIII. CONCLUSION
[TBA]
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