1. What is the process of buyback?
Share buyback programs have become increasingly important in recent years, fueled by political measures.[1] The legal issues of this development lie in stock corporation law -- an area of law often full of national peculiarities -- which is why this article will offer an international overview without claiming to be exhaustive.
A share buyback is the process by which a company organized as a public limited company decides to acquire its own shares from already existing shareholders. Here, the peculiarity of the process is not the transfer of shares, but its capital market regulation. The transfer itself is not different from the conventional acquisition of shares (without the participation of the original issuer).
A share buyback across national borders is subject to the reporting obligation under capital market law.[2] This results from the fact that the implementation of a share buyback program is relevant for the share price development from the perspective of a reasonable investor.[3] Suppose a company announces its intention to buy back its shares. In that case, such a measure offers shareholders (especially short-term shareholders) the opportunity to sell their shares against the background of the knowledge of a secure buyer. Thus, the share buyback also opens the door to possible market manipulation by stock corporations: if someone wants the share price to rise in the short term, the false announcement of a buyback program offers an excellent opportunity for this. Its consequences in terms of damages is not explained in detail here. [4]
An example of a price increase due to the announcement of a buyback program is the gaming company Activision, whose share price rose by 16% compared to the price before the announcement.[5] Understanding the economic consequences of a buyback program brings us closer to the second problem besides market manipulation: there are many insiders among the sellers (CEOs, vice presidents and so on). This problem is then examined in more detail under point 4.
2. Why companies choose them over distributing dividends?
Before going more into detail on potential problem areas, the question that has been raised should be answered: why do companies engage in buybacks?
Buybacks are primarily a way of distributing cash to shareholders without doing so in the form of dividends. This creates greater flexibility because the "payout" or the buyback can be oriented to potential investment opportunities and, therefore, it is not rigidly carried out at the end of the year and this benefits both for the company and for the shareholders. It also has the great advantage for employees that the payment is not linked to the performance of the share, as would be the case with dividends.[6]
Also, buybacks can reduce the cost of capital if equity is replaced by debt. Often, there is also a tax advantage for buybacks over dividends on the part of the shareholders.[7] However, this depends on the respective national tax law and therefore varies greatly.
Moreover, buyback programs have a strong signaling effect: they show that the management considers the shares undervalued.[8] Otherwise, a buyback would not make economic sense from the company’s perspective.
A controversial effect of buyback actions is that they allow managers to achieve short term goals, which will be discussed later.
3. Drawbacks of share buybacks
Apart from the already mentioned danger of market manipulation and insider trading, the most significant criticism is the disadvantageous allocation of capital. A recent example is the way companies have dealt with Trump's tax cuts. Many have preferred to initiate buyback programs instead of investing in employees' salaries or R&D.[9] The tax relief has been a significant source of capital.
This also decouples the remuneration of employees (with stock options) from their productivity because dividends provide much more motivation to try everything to improve the company's financial performance. Despite a buyback is often detached from the company's success, it brings payouts to the employees.
From a macroeconomic perspective, it is argued that debt-financed buybacks are increasing the economy's fragility, and companies are taking on more and more debt to improve their performance on the stock market. The increased debt-to-GDP ratio also decreases job security and the willingness to invest in R&D.[10]
4. Moral hazard of executives to raise the price of stocks
Insider stock sales during buybacks are surprisingly widespread, according to a Washington Post investigation. Based on a Post review of SEC data and regulatory filings, at least 500 executives sold during buyback programs at their companies in just one 15-month period in 2017 and 2018. Chief executives made up more than half of the insider sellers.[11]
These insiders often sell during the short-term price pops that typically follow disclosure of new authorizations or when the companies are actively buying in the market.
Substantial evidence may be the Home Depot case. On Feb. 21, 2017, Home Depot announced a strong quarter and a $15 billion program to repurchase its stock. As the company's price rose the next day, CEO Craig Menear sold 140,372 shares of Home Depot stock. According to SEC filings, Menear was cashing out options he had earned in an old compensation package. As Home Depot explained, the options permitted him to acquire the stock from the company for $26.84 a share and sell it the same day on the open market for an average of $144.33, netting him a $16.5 million profit.[12]
As it is well evident, such transactions would seem to be at the limit of prosecution for insider trading. However, in several episodes (such as Adobe, 2017[13]), the companies claimed that the buybacks plans were pre-established and not related to the operations of the CEO or other executives.
5. Implications for companies’ long-term investments (S&P 500 analysis)
Empirical evidence reveals that use of corporate assets for stock buybacks, whatever the reasons may be, does not limit corporation’s long-term investments. Fried and Wang (2018) found that at the end of 2016, when total stock buybacks were at all-time highs, R&D (Research and Development) investments as a percentage of total sales by S&P 500 companies were also at all-time highs. Furthermore, as measured by R&D plus capital expenditures (CAPEX), total investment spending as a percentage of sales was at its highest level in two decades.[14] Despite stock buybacks reaching a new high in 2018, S&P 500 companies raised CAPEX and R&D investment by 13% in 2018.[15]
On the other hand, the argument is that if capital had not been dedicated to stock buybacks, R&D expenditure would have climbed even higher, but the record cash levels at S&P 500 companies indicate otherwise.
Even after accounting for the $800 billion in stock buybacks in 2018, S&P 500 companies ended the year with a total cash balance of $1.4 trillion.
According to this analysis, stock buybacks have not drained public businesses' resources available for long-term growth; instead, public corporations have more capital than they need given the investment opportunities available.[16]
While the growth in total stock buybacks appears to have had little effect on overall investment levels, another important matter is whether stock buybacks affect investment spending at the individual firm level rather than in aggregate. According to a recent MSCI analysis, the correlation between stock buybacks and investment spending at the business level is substantial, despite critics' fears. Companies that are most actively involved in stock buybacks are also the strongest in R&D and CAPEX spending.[17]
Finally, even if individual companies transfer cash from investment spending to buybacks, that funds are not always taken out of the capital markets. Shareholder cash received via buybacks can be invested in other businesses that, in turn, can reinvest the money to better uses. Instead of draining investment capital from the economy, stock buybacks free up resources to be used more productively. While the most significant public firms have seen net outflows of capital over the last decade, smaller general growth enterprises have seen more than $400 billion net inflows between 2007 and 2016.[18] According to Roe (2018), recent data reveals that money is flowing from larger companies, including those participating in large-scale buybacks, to smaller companies that are more suited to driving innovation.[19]
6. Conclusion
The rise of shareholder activism and the increase in stock buybacks by public companies have been criticized for exacerbating short-termism by forcing companies to focus on short-term stock prices at the expense of long-term value to appease activists or by using stock buybacks to boost stock prices in the short term. The majority of research literature on the short-term impact of shareholder activism on public businesses is favorable, whereas evidence on the long-term impacts of shareholder activism is conflicting. In terms of stock buybacks, we find that long-term investment remains high despite an increase in stock buybacks. Firms must, however, comply with limited disclosure standards when it comes to stock repurchase programs. By improving their present disclosure regime for share repurchase schemes, the SEC could help to increase transparency.[20]
[1] E.g., Corporate Tax Cut of the Trump Administration. [2] E.g., Italy, Austria, USA. [3] UVS Wien zur Ad-hoc-Meldepflicht bei Beschluss eines Aktienrückkaufprogramms, ZFR 2014, 189. [4] Marktmanipulation durch irreführende Ad-hoc-Information über Aktienrückkäufe, ecolex 2016, 298. [5] The Washington Post, Company insiders are selling stock during buyback programs and making additional profits when stock prices jump. And it’s legal, November 6, 2019, Putka. [6] Committee on Capital Markets Regulation, Short-Termism, Shareholder Activism and Stock Buybacks, 2020. [7] For the US see Fried in his hearing on Examining Corporate Priorities: The Impact of Stock Buybacks on Workers, Communities, and Investment before the Committee on Financial Services in 2019. [8] Committee on Capital Markets Regulation, Short-Termism, Shareholder Activism and Stock Buybacks, 2020. [9] The Washington Post, November 6, 2019, Gary Putka. [10] https://hbr.org/2020/01/why-stock-buybacks-are-dangerous-for-the-economy. [11] The Washington Post, November 6, 2019, Gary Putka. [12] See id. [13] See id. [14] Fried and Wang, Are Buybacks Really Shortchanging Investment?, Harvard Business Review (March-Apr. 2018). [15] https://www.goldmansachs.com/insights/pages/top-of-mind/buyback-realities/report.pdf [16] Fried and Wang, Are Buybacks Really Shortchanging Investment?, Harvard Business Review (March-Apr. 2018). [17] See Ric Marshall, Panos Seretis and Agnes Grunfeld, Taking Stock: Share Buybacks and Shareholder Value, MSCI 17 (Aug. 2018), available at https://www.msci.com/documents/10199/ba01b4c4-683c-74ca-339e-f422df5d879e. [18] Fried and Wang, Are Buybacks Really Shortchanging Investment?, Harvard Business Review (March-Apr. 2018). [19] See id. [20] Committee on Capital Markets Regulation, Short-Termism, Shareholder Activism and Stock Buybacks, 2020.
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