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Message: Re: Share buyback issue "put to bed" - Patientman

Re: Share buyback issue "put to bed" - Patientman

posted on Mar 10, 2008 11:14AM

From the "CPA" Journal - Cleanser, if you keep going with this issue, consider yourself a true "pit-bull"!  I hope you drop it, pit-bulls aren't very intelligent.

 Scroll down to "SEC Rules"

THE CPA IN INDUSTRY

August 2000

CORPORATE SHARE BUYBACKS

By Joseph R. Oliver and Katherine S. Moffeit

In an era of abundant IPOs and stock placements, corporations also are announcing record buybacks of their outstanding shares. Repurchases serve a variety of purposes, from increasing earnings per share to providing stock for employee benefit plans.

Although buybacks can be a sound part of a publicly held corporation’s financial strategy, they are complex endeavors that involve SEC rules, proper accounting and disclosure under GAAP, and certain federal income tax implications.

Reasons for Buybacks

A recent poll by the Financial Executives Institute (FEI) identified the following top reasons for repurchases of stock by publicly held corporations:

  • Improving earnings per share or return on equity,
  • Distributing excess cash to shareholders,
  • Fine-tuning capital structure by changing the ratio of debt to equity, and
  • Acquiring stock at low cost for employee stock option and stock purchase plans while hedging exposure to the exercise of employee stock options.

Earnings and capital markets. Although many fast-growing companies in the headlines do not currently report profits, traditional investment analysis still examines elements such as earnings per share, price-earnings ratios, and dividends per share. These measurements benefit when fewer shares are outstanding. Often, by expressing confidence in the company’s future and its share values, a buyback announcement from the board of directors boosts share prices, which increases the stock’s price-earnings ratio.

Announcing its intent to reacquire stock signals to the capital markets that the corporation has excess cash and is willing to use it for the direct benefit of shareholders, many of whom prefer increased share values to dividends. Cash dividends are subject to federal income tax rates up to 39.6%, but long-term capital gain on the sale of stock is taxed at no more than 20% for federal purposes. A shareholder may sell as many or as few shares as desired, depending on the need for cash or the preference to remain invested.

Dividend policy. If a company pays cash dividends, it generally must aim for stable dividends. Shareholders that rely on dividend income will not invest in a corporation with fluctuating dividends. Swings in dividends per share also send mixed signals to the financial markets and may themselves influence share values.

In years of high cash inflow, a company can use excess cash for new projects or acquisitions, but opportunities offering a return exceeding the cost of capital vary from year to year. A corporation may retain unused cash for later and invest it temporarily in interest-bearing securities. However, if the company shifts a significant part of business resources into low-yield investments, the overall return on assets and the market value of outstanding shares decreases. Repurchasing stock may be a better use for excess cash.

Debt-to-equity ratio. For many companies, an important objective is the fine-tuning of the ratio of debt financing to equity financing in order to maintain a high credit rating, borrow at low interest rates, and minimize the weighted average cost of financial resources. While creditors require a cushion of shareholder equity, repayments of maturing debt sometimes increase the percentage of financing from equity and the average cost of capital. Adjustments to capital via share repurchases adjust the ratio and minimize the cost of capital.

Employee compensation. Companies often use reacquired shares for employee stock benefit plans, performance-based compensation arrangements that avoid the $1 million cap of IRC section 162(m), and other incentive and retirement plans. Increasing the percentage of stock held by employees sometimes decreases the possibility of a hostile takeover. Reselling unneeded stock may increase paid-in capital. If a repurchase program coincides with a period of rising stock prices, the corporation can hold shares in the treasury to appreciate during the interim. Buying stock when prices dip or across a period of time reduces the likelihood that a company will need to purchase shares at high prices to satisfy peak employee demand.

SEC Rules

The company itself is covered by the SEC rules that prohibit insider trading in a public corporation’s stock. A corporation may not repurchase its own stock before any material inside information is reported to the public; a company should announce the decision to buy back stock before commencing actual purchases.

The SEC’s complex section 240.10b-18, referred to as Rule 10b-18, is generally regarded as the safe harbor for stock buybacks, although it does not provide absolute protection from litigation. Highlights of Rule 10b-18, which also provides various exceptions and traps, include the following:

Time. A corporation generally may not perform the opening trade on any day and may not trade during the 30 minutes before the market closes. The same restrictions apply to any affiliated purchasers, such as advisors involved in the decision to buy back stock.

Volume. During any one day, a corporation generally may not buy more stock than the larger of one round lot (generally 100 shares) or the number of round lots nearest to equaling 25% of the stock’s average daily trading volume for the four calendar weeks preceding the start of the buyback program.

Block purchases, which may be privately negotiated outside of the market, typically are not subject to the volume restriction if each block--

  • has a purchase price of at least $50,000 including at least 5,000 shares,
  • has a purchase price of at least $200,000, or
  • includes 2,000 shares (20 round lots) or more and is at least 150% of the stock’s average trading volume for the four calendar weeks preceding the buyback period.

Price. A corporation generally may not reacquire its stock with a purchase price or bid that exceeds the greater of the highest current independent bid quotation or the last independent sale price. Affiliated purchasers are bound to the same ceiling.

Broker or dealer. Only one broker or dealer may be employed on any one day to buy stock or make bids for the corporation and any affiliated purchasers.

Assume, for example, that X Corporation plans to repurchase shares of stock for employee benefit plans and that after the board of directors’ decision is announced, there is no material inside information. Before the buyback begins, X informs officers, employees, and directors of their responsibilities under insider trading rules. No individuals involved in X’s decision purchase any shares during the buyback period unless they coordinate their purchases with X. On Monday, X begins reacquiring shares through one broker, avoiding the opening trade and the last 30 minutes before the market closes. The top independent bid quote on Monday is $30. The last independent sales price is $29.50. None of the bid or settlement prices for shares that X buys exceed $30. X’s average daily trading volume for the last four weeks has been 120,000 shares. Monday’s market repurchases are limited to 300 round lots (25% of 120,000 shares), but one block purchase of 5,000 shares from a large shareholder is negotiated for a total cost of $147,500. On the basis of the facts, X’s buyback appears to comply with Rule 10b-18.

A smaller publicly held company’s legal department may lack the familiarity, time, or confidence to oversee occasional buybacks. Large brokerage firms have departments specializing in corporate stock repurchases. A corporation considering repurchases might interview several brokers and inquire about—

  • their Rule 10b-18 departments,
  • internal compliance systems and controls,
  • standard agreements with clients covering Rule 10b-18, and
  • indemnification of a client in the event that the broker violates SEC rules.

A corporation that regularly repurchases stock might rotate and monitor brokers to make sure that shares are consistently bought at good prices, a high level of service is delivered, and the CFO or other officers and directors have access to a depth of talent and expertise.

 

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