Stock Repurchases

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Overview of a Stock Repurchase Program

When the board of directors authorizes a stock repurchase program, it is telling investors that it feels the stock is currently undervalued. This action also tends to increase earnings per share, which in turn can lead to an increase in the stock price.

The best way to establish a strong case for a minimum stock price is for the Board to approve a long-term repurchase program that allows for pre-approved stock purchases at a specific trigger price. For example, if the Board authorizes the company to buy back shares whenever the market price of its stock drops to $5, then this establishes a floor of $5, below which the stock’s price is unlikely to drop. This tends to reduce the variability of the price, and may attract a group of investors who are less tolerant of risk. The key component of such a buy-back program is a long-term commitment to it, since its non-renewal may trigger a sudden price drop that will result in some investor turnover.

Problems With a Stock Repurchase Program

A company can run afoul of its bank credit facilities with a stock buyback program. Banks frequently disallow stock buybacks as a condition for a loan or line of credit, on the grounds that the company is simply extracting cash from the bank in order to pay its investors. The wording of a credit facility usually restricts the issuance of dividends, and a stock buyback program can be construed as the issuance of dividends.

A stock buyback program can also cause a company to contravene the Securities Exchange Act of 1934. In its Section 9(a)(2), the Act states that it is illegal:

To effect… a series of transactions in any security registered on a national securities exchange… with respect to creating actual or apparent active trading in such security, or raising or depressing the price of such security…”

This is an obvious problem, since a stock buyback program absolutely will at least keep the price of a stock from dropping below the program’s trigger price.

The Stock Repurchase Safe Harbor

Fortunately, the SEC’s Rule 10b-18 provides a safe harbor from liability for manipulation under the preceding Section. However, to obtain safe harbor coverage, the repurchase program must satisfy (on a daily basis) the following four conditions:

Centralized purchases. All purchases on behalf of the company must be made by a single broker/dealer on a single day. This means that the company should authorize a single broker/dealer to handle virtually all repurchases.
Purchasing boundaries. Companies cannot bid or purchase the day’s opening transaction, nor can they do so within the last 30 minutes of the close of the trading session. However, companies with a public float value exceeding $150 million and average daily trading volume over $1 million can bid or purchase within 10 minutes of the close of the trading session. Also, bids and purchases are allowed in after-hours trading, as long as the company does not enter the opening bid, and the purchase price does not exceed the lower of the closing price in the equity’s principal market, nor any lower bids subsequently reported in other markets.
Purchase price. The purchase price may not exceed the highest independent bid or the last independent transaction, whichever is higher. If the stock trades on the OTC Bulletin Board system or the pink sheets, then the price cannot be higher than the highest bid obtained from three independent dealers.
Purchasing volume. The daily purchasing volume cannot exceed 25 percent of the average daily transaction volume (ADTV) during the four preceding calendar weeks. However, the company may make one block purchase per week without being subject to this limitation, as long as the company makes no other purchases that day. Also, the block purchase cannot be used to calculate the ADTV (which would otherwise likely increase it).

If the repurchase plan does not meet one of these conditions, then the safe harbor is removed from all repurchases made on the day when the condition was not met. Also, the safe harbor is not effective if the company is aware of material, nonpublic favorable information. Therefore, the company must be current in its disclosures before engaging in repurchasing activities.

The safe harbor is also not available (with some exceptions) during a merger transaction with another company, which spans the period from the public announcement of the merger, until either the completion of the transaction or the completion of voting by the target company’s shareholders.

In short, the SEC has designed the requirements of the safe harbor to keep a company’s repurchase activities from unduly impacting the price of its stock, both by controlling the timing and size of purchasing transactions.