What is a share repurchase agreement?
When a company decides to repurchase its own shares, it enters into what is known as a share repurchase agreement. This legal contract outlines the terms under which the company will buy back its own shares, usually from current shareholders. Share repurchase agreements are often offered to employees and current shareholders, and can be part of a compensation package or presented as an investment opportunity.
These agreements are essentially a simple sale of stock where the price is established in advance. For this reason, the repurchase price is typically adjusted to either increase or match the current market price, such as through a formula relating to the fair value or book value of the stock at the time of repurchase . Share repurchase agreements can be for shareholders that are leaving the company, but the agreement can also be structured in a way that leaves the decision to repurchase the shares to the discretion of the corporation, although in practice they are typically repurchased within a short period after a specific triggering event.
Triggers for share repurchases include deaths, a shareholder’s resignation, general retirement and other circumstances in which an employee or current shareholder is exiting the company. Other types of triggering events include: Many shareholders of closely held companies find shares of stock illiquid and participate in a share repurchase agreement so they can cash out their investment. Repurchase agreements work to prevent outsiders from acquiring shares when a shareholder is dead or moves on from the company. Share repurchase agreements also establish the price that a corporate stockholder can sell his or her stock for, also allowing companies to control when shares are sold.
Share buybacks: Different types
Share repurchase transactions can take a variety of forms, depending on the objectives of the parties and the facts surrounding each particular transaction. The more common forms of share buybacks are open-market share purchases, tender offers and purchases negotiated directly with the shareholders. An open-market repurchase is the simplest and most common form of share repurchase. A repurchase program is usually announced through one or more press releases or SEC filings over a period of time. Shares are then purchased in the open market on a periodic basis (for example, shares may be purchased on a daily basis for a six to twelve month period). Share repurchases are typically made at prices that are not materially different from the market price for the repurchased stock at the time of the repurchase without regard to the prior trading history. Repurchases of this nature may also be made pursuant to Rule 10b-18, which provides issuers that comply with certain restrictions on the manner, timing, price and volume of repurchases with a safe harbor with respect to liability for stock market manipulation (see the section entitled Rule 10b-18)—the "safe harbor rules," which are discussed below. Tender offer considered to be more effective than the offerings made under SEC Rule 10b-18 but which can result in short-swing profits for executives (10b5-1 plan trades may not be used in most instances) and stock trading suspensions. A tender offer may also be conducted subject to Rule 13e-4 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), or the tender offer rules, which relates to stock buybacks. Generally, company stockholders are invited to sell their shares in exchange for cash based on a specified price formula. This type of repurchase transaction will typically take the form of a self-tender. A self-tender is a tender offer in which a company itself is the "bidder," making an offer to acquire its own securities rather than those of a third party. In connection with this format, the tender offer will specify days (which must not be fewer than 20 days) within which the offer is available. Consistent with Rule 10b-18, share pricings are made without regard to prior trading history. Unlike the Rule 10b-18 repurchase program, such tender offer will need to be commenced through the filing of a Schedule TO and other offer documents, which will require the corporation to circulate the material to all shareholders. Again, certain companies have also implemented stock purchase programs through which shareholders may sell their shares back to the company. It should be noted that if the tender offer results in transfer of control over the target company, such transaction may be considered to be a business combination characterized by the state takeover statutes, corporate constituencies laws and SEC rules. The third type of share repurchase is a negotiated purchase with shareholders, which typically do not involve any registration statement turn filed with the SEC. These types of share repurchases may take the form of (i) a tender offer following the rules of Rule 13e-4 under the Exchange Act or (ii) an unregistered share exchange. This type of repurchase is often considered to be the simplest. Under such transactions, the company would simply reach out to shareholders, determine pricing and other terms and conditions, and proceed to closing following the execution of binding documentation.
Legal aspects of share repurchase
Share Repurchase Agreements are governed by a combination of state and federal laws, and the regulations tend to vary depending on the jurisdiction. In general, a Share Repurchase Agreement must comply with all securities law as well as corporate law considerations. The primary federal authority regarding the legality of both share repurchases and other actions to repurchase debt instruments is Rule 10b-18 under the Securities Exchange Act of 1934, which provides issuers with an affirmative defense from liability associated with manipulating the market provided the repurchase is made in accordance with the safe harbor requirements of the rule.
Most state laws have corresponding laws concerning the legality of corporate share repurchases. These state codes vary by jurisdiction, but also generally provide the mechanism for self-funded share repurchases using surplus, such as "the amount of assets thus transferred must be less than the surplus of the corporation immediately before such transfer."
These laws also govern liquidating distributions. For example, under California Corporations Code Section 506, Share repurchase agreements must be paid from the "available disbursements or net assets of the corporation, after payment of [all] debts, obligations and liabilities for all taxes, terms of preference and other provisions with respect to its shares."
In addition to the legal regulations and principles, shareholders may also have remedies for breach of contract or breach of fiduciary duty against the company based on fraud or collusion.
Why companies buy back shares
Share repurchase agreements are more common, now, than ever before. So what is the purpose of a company repurchasing its shares? In fact, understanding the underlying motivations for the buyback transactions is crucial when considering whether to participate in one. This section will set forth many of the strategic benefits that may be derived from a share buyback.
Share buybacks are frequently implemented as a means to boost the stock price and improve its financial ratios. Historically, companies have occasionally chosen to fix their ability to pay dividends by purchasing their stock from stockholders for the purpose of selling the shares at a later time when the price is higher. This is done to increase the price of a company’s shares. Another reason companies implement this strategy is to counteract stock dilution from employee benefit plans and stock options. Share repurchase agreements can mitigate the effect of stock options on a company’s earnings per share (EPS). One of the main reasons for companies to institute employee benefit programs is to improve employee morale and increase productivity. However, one of the drawbacks is that each time stock options are issued, the number of shares outstanding increases which often has a negative effect on earnings per share. The share buyback counteracts this by reducing the number of shares outstanding, thereby driving up the price of each individual share as well as the earnings per share. Of course, buybacks only work in this fashion if the stock price is below intrinsic value. Buybacks are also an effective way to remove "dead weight" from the market to give control to one shareholder or a small group of shareholders. Share repurchase agreements are one way for a company seeking to go private to cash out its shareholders. Share buy backs can allow companies to have a less wrecked capital structure in addition to increasing the amount of equity stemming from net income. Share repurchase agreements can also be a strategic choice for companies looking to combine or consolidate capital stock as well as obtain the necessary capital that has been required for long-term growth. For example, a company seeking to acquire another company might be able to use its own shares instead of using its cash position to complete the acquisition. It can also utilize a share buyback in lieu of issuing new shares.
Effects on shareholders and market values
In the most general sense, share repurchases benefit shareholders in two ways, one quite direct and tangible, and the other much more intangible and difficult to quantify. First, by buying back its own shares rather than using excess cash for dividend payments, a company arrives at its shareholder payout by using retained earnings rather than taxable income, providing a more tax-efficient reward for shareholders. Second, and much more nebulous, a share repurchase signals a message of corporate strength. In the current economic environment, investors have become understandably suspicious and wary of the financial health of companies, and arguably many are slow to trust corporate management. Yet, companies poised to repurchase their own stock, particularly in large amounts, send a positive sign to the market and investors that their cash reserves remain healthy and the balance sheets are stable.
Similarly, the market may react negatively to a company seeking an agreement for share repurchase, interpreting the request for board authorization as evidence that the company has lost market and investor confidence and is unable to sustain a good level of cash flow. In essence , the market may take a lack of stock buyback activity as a lack of sufficient capital or investor loyalty.
Because a share repurchase does not mean free money for a company, the potential costs must be considered before any buybacks can commence. For instance, if a firm buys back stock that is then reduced into treasury stock, it enjoys quite a bit of freedom with respect to how it uses the newly purchased shares. In contrast, if shares are acquired by tender offer, the firm is subject to restrictions governing a tender offer. Generally, if a tender offer were to be used to repurchase shares, the firm could only offer to repurchase up to 15 percent of the outstanding shares on a pro-rata basis over a sixty business day period (although in no case may shares be purchased over a period in excess of ten business days). This generally means that manipulation and timing of a tender offer is difficult, if not impossible. Similarly, a slow-moving tender offer cannot accomplish a sudden change of capital structure. But if a company can take advantage of this slow timetable, it may be best served by preparing and announcing the tender offer several months ahead of time to provide confidence to investors about the buyback program.
Criticisms and risks of share repurchase programs
Share repurchase programs are not immune from criticism. Concerns have been raised that they can be used to manipulate financial metrics, such as earnings per share, and to further short-termism. For instance, some believe that share repurchase programs can be structured in ways that "help" companies meet or exceed their earnings targets. In fact, some critics of share repurchase programs have argued that the decision to repurchase shares should be made on substantive grounds (such as their use as an important capital allocation tool) instead of to meet certain earnings or stock price metrics.
Others have pointed out that share repurchase programs may allow directors and executives to obtain alternatives to cash bonus compensation without threatening to surpass thresholds which might trigger a "bonus buster" rule or break the applicable incentive compensation plan. Some also believe that the current regulatory framework for share repurchase programs is inadequate to achieve their intended purpose of meeting market needs and limiting manipulation – pointing out that shareholders may be adversely affected by share repurchases. For instance, identifying shares in the context of a repurchase program might be difficult in order to prevent abuse. One recent SEC decision deemed issuers offering an alternative "buy back" of shares from the issuer at a premium price to be a "tender offer" under the Williams Act, causing speculation that accommodating buy backs might require an FTO. Perceptions of share repurchase programs may also depend on the state of the economy: During periods when the economy is expanding, many view share repurchase programs favorably. However, when the economy is stagnant, some prefer that companies use excess cash for R&D, investments in plants and equipment or employee compensation. These critics write that the productive capacity of the economy needs to be considered in addition to the financial benefit of repurchasing shares.
Trends in share repurchase
The pace of share repurchase activity has resided at a high level over the past few years. For example, 2018 saw an estimated $1.1 trillion in share repurchase activity. As noted in our recent blog post, share repurchases may be conducted in connection with mergers and acquisitions, "Dutch tender offers," Rule 10b5-1 plans or through open market purchases. This level of activity has drawn the attention of the SEC, the IRS and shareholder advocacy groups.
The SEC has focused on institutions that might be interested in advancing shareholder proposals relating to share repurchases, either to provide for mandatory shareholder approval prior to conducting repurchases or to impose moratoriums on repurchases in certain market conditions. The IRS has pursued guidance for the application of certain transfer pricing treatment to the repurchase context-the result of which was separated out as two separate guidance efforts. Taxpayers should be aware of how the rules addressed in this guidance might apply to their businesses .
Finally, shareholder advocacy groups have, for a time, been vocal in their criticism of share repurchases. Advocates have argued that companies should invest in projects that will grow their business rather than use free cash flow to fund share repurchases. This came on the heels of a study by The Federal Reserve Bank of New York predicting that share buybacks contributed greatly to the rise in corporate debt. With lower interest rates, the cost of debt is at a historic low, but if the Federal Reserve raises interest rates, borrowing will become more expensive and this is what makes critics of share repurchase activities concerned. Critics argue companies who borrow money to fund their share buyback programs might find themselves in a pinch, needing to pay dividends and feed creditor obligations despite not having cash flows to cover such payments.
Despite the criticism, however, share repurchases have continued at a steady pace.