What is it and why do it.
The term share buyback refers to a corporate finance strategy used by companies to purchase their own shares that are already circulating in the market. But why do companies feel the need to strategically buy back their shares? The reasons are multifaceted and may vary from company to company but let’s see which are the main attractive reasons for a share buyback.
First and foremost, a company may decide to buy back its shares because it feels that its shares are undervalued in the market. Such a finance strategy bursts confidence into the market, signaling the management’s trust in the performance of their business, thereby potentially leading to an increase in the share’s prices. This also creates demand in the share market, propping up share prices.
Second, companies that have an excess in cash may consider buybacks as a way to return money to shareholders. Instead of paying dividends, which are taxed for shareholders, a company may use share buybacks as a tax-efficient way to give back money to its investors.
A company may also elect to pursue this course of action as a strategy to optimize its capital structure. Indeed, by observing market trends, a corporation may discern an imbalance in its equity-debt ratio and may consequently prefer to repurchase a portion of its shares and allocate resources to the debt market. This scenario may arise when the debt market is notably cheap, rendering it advantageous for a company to assume a greater proportion of debt relative to equity.
In addition to the aforementioned market factors, share buy-backs serve a more common but essential purpose in private companies. Specifically, this instrument of corporate finance is frequently employed within private corporations as a mechanism to address significant shareholder-related issues. For instance, in scenarios where a shareholder expresses a strong desire to exit the company, or if he, unfortunately, passes away, and the residual shareholders lack the necessary liquidity to acquire their shares, the corporation may opt, if it doesn’t find an investor to buy in the company, to acquire its own shares as a strategy to alleviate the impasse.
This mechanism is commonly employed in many jurisdictions, but some countries have seen a much larger use than others and therefore they have structured are more specific legislative framework to regulate this commercial practice. As a matter of fact, we are now going to compare the UK discipline of share buybacks with the Italian one.
UK discipline
In the UK, the discipline of share buybacks is contained in the Companies Act 2006 and it pertains to the so-called “Capital Maintenance Doctrine”. This doctrine seeks to control all extractions from the corporate treasury no matter how they are dressed up. As a matter of fact, the legal capital of a company may be used to run the company’s business but also to pay up the creditors in case of a solvent or insolvent winding up. The Capital Maintenance Doctrine aims to give a direction of what extractions are permissible and what payments to shareholders are prohibited.
In this framework, the general rule prohibits limited liability companies from the acquisition of their own shares. However, the impact of this ban is attenuated by other provisions in the Act whereby companies are permitted to purchase their own shares and to issue redeemable shares[1]. In fact, share buyback is one of four statutory gateways, alongside dividends from realized profits, reduction of capital, and solvent winding up, through which money coming from the corporate treasury can be extracted and given to the shareholders.
Some exceptions to the rule are granted to both private and public companies. In fact, share buybacks financed through distributable reserves and the proceeds of a fresh issue of shares made for the purpose of financing the buybacks are permissible. Moreover, private companies may also finance their buybacks out of capital. A buyback by private companies can only be funded out of capital once the company has depleted all its “available profits” and the proceeds of any fresh issue of shares made for the purpose of funding the buyback. This is also known as the Permissible Capital Payment doctrine (PCP). In other words, with this provision the law extends, even though only for private companies, the funds available for the purchase of own shares beyond distributable profits and the proceeds of fresh issue.
The exceptions that grant companies the possibility of purchasing their own shares may be considered in breach of the Capital Maintenance Doctrine, as company funds are given back to shareholders. Nevertheless, both shareholders and creditors are protected by other provisions of the Company Act 2006. In particular, shareholders need to authorise the transaction or purchase of their own shares with an ordinary resolution of the company when dealing with a buyback out of profits. Therefore, shareholders are generally aware of what’s happening and the majority of them need to be on board with this operation in order to continue pursuing it. The resolution needs to address whether the buyback is a general one or if it identifies a specific class of shares to purchase. It must also specify the maximum number of shares to be bought and their minimum and maximum price (Section 701). If the buyback is financed out of capital, for private companies only, the need for further reassurances and protection for shareholders is manifested through the need for a special resolution rather than an ordinary one (Section 716).
At the same time, also creditors find protection in the CA 2006. As a matter of fact, when shares are purchased, they must be canceled, and the issued capital reduced accordingly. This triggers the obligation to requisite transfer to a capital redemption reserve. This is a non-distributable reserve in which amounts are transferred following the purchase of shares. The ultimate consequence of this accounting adjustment is that the company’s legal capital is not reduced, thereby ensuring the creditor’s protection. As opposed to canceling the shares, purchased shares can also be held in the Treasury for later re-sale or re-allotment or cancellation. Moreover, when a buyback is funded through a private company’s legal capital, what effectively happens is that the legal capital of the company is reduced. Therefore, to ensure that creditors feel protected in their rights it is necessary to provide a solvency statement to prevent abuse and to ensure that the company is solid and that there are no grounds on which the company would be found unable to respond to its obligations. This clearly creates a civil as well as criminal liability on directors.
Italian discipline:
Moving on to the Italian regulatory framework for share buybacks, it is composed of different legal sources, and it is generally inspired by principles of transparency, fairness and investors protection. Among the multiple aforementioned aims that this commercial practice is able to achieve, in the national context it is mainly employed in four situations: to invest available assets, to distribute profits to the shareholders and, only in listed companies, to stabilize the company’s share value and to avoid hostile takeovers.
First of all, when it comes to buying a company’s own shares, the national discipline provides for limits with the aim of trying to avoid some of the risks that this operation may entail. The most important one, which is applicable to every type of company, is the limit of distributable income and distributable reserves[2]: the underlying legal ratio aims at not endangering the company’s share capital by only employing otherwise available resources. The same principle was also present in the previous and stricter restrictions which were then modified by an EU Directive in 2006[3]: they used to provide for a maximum ceiling of 10% of the share capital as limit of purchasable shares. Secondly, it’s important to verify that the shares in question have been paid-up in full before even thinking of purchasing them.
Taking a closer look to the specific framework concerning listed companies, another limit emerges: said companies can only buy up to a fifth of their own share capital, even including in the calculation the shares held by their subsidiary companies. Moreover, there are many other formal and procedural obligations that derive from the multiple specialized legal sources that govern commercial practices on the stock market. Among those, there’s the general principle of equal treatment between shareholders[4], which is also better defined in detail by the Italian National Commission for Companies and the Stock Exchange (CONSOB), together with disclosure obligations and additional requirements to the approval procedure.
In case of breach of such limits, the company will be forced to sell those exceeding shares within a year and, if impossible, to annul them and to proportionally reduce its own share capital. There’s also a possibility to raise an action against the company’s board, even entailing their criminal responsibility, in case their managing choices cause damage to the integrity of the share capital or of the distributable reserves.
Furthermore, the decision-making power on the topic belongs to the general meeting of shareholders, which is also the body responsible for deciding whether to distribute the year’s profit, assuming that there are no previous losses to cover. The legal reasoning behind this requirement is evident: only shareholders, who would directly benefit from the profits’ distribution, can decide to forgo it in order to invest them in a share buyback. In addition, this commercial operation has the power of slightly shifting the previously established balance of powers within the corporate structure and for this reason the decision can only be left in the hands of those who are directly concerned by it.
But once the shares are purchased following all the above-mentioned conditions, how does the Italian framework regulate the possession of said shares? The general aim of this discipline is, on the one hand, to constrain the managers’ choice in a way that is complaint with the corporate interest and, on the other hand, to neutralise the multiple rights that shareholders usually hold. On the first point, the procedural provisions are less strict than what previously mentioned for the actual purchased: the shareholders’ assembly only has to authorise the purchase[5], without even having the power of actually impacting the validity of the buyback itself. On the second topic, the nullification of the shares’ power is obtained under two different points of view: administrative rights and property rights. In fact, once the company completes a buyback, the distributable profits that would normally go to a “normal” shareholder are proportionally re-allocated to the other shares. Moreover, the right to vote that is usually attached to the share is suspended but it also counted a part of both the constituent and the deliberative quorum: from a practical point of view, this means that these shares are going to have the same effect of a dissenting vote when trying to get the assembly’s approval, basically making the majority much more difficult to reach. In listed companies this obstacle is slightly overcome by the fact that their specialised discipline explicitly excludes those shares from consideration when calculating the deliberative quorum.
Conclusion
To sum up, this commercial practice is starting to gain more ground in recent years, abroad even more than in the national context, and this increase is reflected by the differently articulated legislative frameworks in force in various countries. As an example, we compared the Italian discipline with a more permissive one, such as the English regulation, to show the different approach that the two countries have on the topic: in particular, while the two countries have similar procedural requirements when undergoing a share buyback, the UK legal framework is more permissive when dealing with private companies. Notably, in cases where distributable profits are lacking, UK private companies may utilize their legal capital to facilitate share buybacks. In contrast, the Italian legal discipline strictly prohibits such actions, thereby ensuring a higher level of protection for shareholders and creditors.
Bibliography
[1] Ferran, Eilís, Elizabeth Howell, and Felix Steffek, 'Share Buy-backs and Redeemable Shares', Principles of Corporate Finance Law, 3rd edn (Oxford, 2023; online edn, Oxford Academic, 19 Oct. 2023), https://doi.org/10.1093/oso/9780198854074.003.0008, accessed 13 Apr. 2024.
[2] Italian civil Code (1942), art. 2357, Purchase of own shares
[3] Directive 2006/68/EC
[4] Unified Financial Act, art 138a
[5] Italian Civil Code (1942), art. 2357 ter, c. 1