An organization engages in stock repurchases when it buys back shares from investors. Stock repurchases are used to stabilize a stock price, return funds to investors, and improve earnings per share. More specifically:
- Price stabilization. The board of directors believes the market price of the stock is too low. If so, there should be a well-publicized plan in place to buy back shares whenever the market price drops below a certain threshold. This approach also tends to attract investors who like a more stable stock price.
- Shareholder pressure. The board is responding to pressure from investors to return funds to shareholders. An alternative is to issue a dividend.
- EPS improvement. The resulting smaller number of shares outstanding will increase the calculated earnings per share.
Problems With a Stock Repurchase Program
Before engaging in a stock repurchase program, the board of directors should be aware of the following issues:
- Covenant breach. A loan covenant may not allow a repurchase program until a loan has been repaid, on the grounds that the bank must be paid back before cash can be distributed to investors.
- Legal violation. The Securities and Exchange Act of 1934, section 9(a)(2), does not allow activities that will alter the price of a security that is traded on a national securities exchange. This is an issue, since stock repurchases tend to keep a stock price from dropping. This problem is dealt with next.
The Stock Repurchase Safe Harbor
The concern just raised regarding the legality of stock repurchases is covered by the SEC's Rule 10b-18. This rule creates a safe harbor for a company that buys back its stock. To be covered by this safe harbor provision, a business must meet the following requirements every day:
- A single broker/dealer must make all purchases on the company's behalf.
- The company is not allowed to bid or purchase the opening transaction of the day, nor any transaction within the last 30 minutes of the end of a trading session. This limitation for the end of the day is reduced to 10 minutes if the company's public float exceeds $150 million and the average daily trading volume in its stock exceeds $1 million. Under certain conditions, the company may engage in bids and purchases in after-hours trading.
- The price paid on stock repurchases cannot be higher than the highest independent bid or last independent transaction. If the stock is instead trading on the OTC Bulletin Board or Pink Sheets, then the high price limitation is based on the highest bids from three independent dealers.
- The volumes of shares repurchased can be more than 25% of the average daily transaction volume through the four immediately preceding weeks. The business can avoid this limitation if it makes one block purchase per week, with no other purchases occurring on that day.
The safe harbor provision is not available under the following circumstances:
- Stock repurchases do not meet any one of the preceding conditions.
- The company has not publicly issued information about material, favorable information about the business.
- During the period of a merger with another entity, from the announcement date of the merger to the completion of the transaction.
In essence, the safe harbor provision is intended to keep a company from unduly altering the price of its stock through its repurchase activities.