What Are Stock Buyback Rules?

Wall Street loves stock repurchases. In the fourth quarter of 2019, companies on the S&P 500 spent an estimated $189 billion buying back their own shares from the stock market. It was the highest in three quarters but not the highest on record. In the final quarter of 2018, that number was about $223 billion, a high point on a decade-long trend. Have stock buyback rules changed recently? Let’s find out.

5 Second Takeaway: Stock Buyback Rules

  • Reduces the number of shares outstanding
  • Earnings-per-share go up
  • Stock value goes up
  • Earnings are “diluted” when the number of shares outstanding increases, reducing per-share earnings.
  • Share buybacks have become a significant component of how public issuers return capital to shareholders

In all, since 2010, companies on the S&P have poured more than $5.3 trillion into repurchasing their own shares. Analysts say buybacks have been a driving force in the decade-long bull market.

But there’s some argument about whether they’re good for the economy. To understand the debate, you have to understand how stock buybacks work. And what the stock buyback rules are.

What Is A Stock Buyback?

stock buyback rules

The principle of stock buyback rules is simple. On the one hand, companies can obtain additional capital by issuing shares and letting others “own” a piece of the company.

On the other hand, they can also do the exact opposite by “buying out” existing shareholders.

Company ownership is Diluted when issuing shares and consolidated when buying them back.

Why Would Companies Buy Back Shares?

For many reasons. Hence why stock buyback rules exist.

Liquidity

Firstly, having excess liquidity and no better alternative with respect to using it. 

Undervalued Shares

Secondly, considering the shares undervalued. If you buy back 1000 shares at $10 each and issue 1000 shares when the price reaches 20 bucks, you essentially make money without ownership dilution. 

Making The Numbers Look Good

Thirdly, making certain metrics look more attractive. For example, your earnings per share or EPS will be higher if you have fewer shares.

An Alternative To Dividends

Four, for implementing an alternative to dividends or making shareholders happy through asset appreciation rather than handing him money directly. Tweaking buyback approaches based on market conditions arguably involves fewer headaches. The main idea is that the market, for example, responds less aggressively to share buybacks as opposed to lowering dividends. 

Questionable Reasons

Five, questionable reasons, such as a bunch of decision-makers who own stocks themselves initiating a buyback. Which, conveniently for them, makes share prices go up. In other words, they are buying back shares because it’s in their best interest than that of the business.

Are Buybacks Good For The Economy?

Skeptics say the money used on stock buybacks would be better spent elsewhere, like building new factories or exploring new opportunities altogether. Meanwhile, for proponents, buybacks put money right where it belongs: With shareholders. 

Harvey J. Goldschmid, former general counsel at the SEC, was a firm believer that stock repurchases made by company managers with the material inside information can disturb “the integrity of the markets.” With stock buyback rules, that does allow some protection.

Disturbing The Integrity of The Market

Stock Buyback Rules

“The integrity of the markets is disturbed if insiders, including managers in a company, purchase shares on the basis of material information,” says Harvey J. Goldschmid, general counsel of the SEC in Washington, D.C

That applies whether the insider purchases stock for his own account or for the company.

Think of a situation where a company knows shares soon would double in value due to a discovery—without telling shareholders about the discovery. That creates a kind of unfairness that is fraudulent.

You know this as insider trading. And you likely know someone guilty of it who spent jail time: Martha Stewart. Even though the scenario was the opposite, it’s still action based on insider information. 

What Is Insider Trading?

Insider trading refers to the practice of buying or selling a publicly-traded company’s securities while in possession of knowledge the public does not have.

By non-public information, I mean that the information is not legally out in the public domain. Basically, only a small handful of people directly related to the information possessed.  

An example of an insider may be a corporate executive or someone in government who has access to an economic report before it is publicly released.

Take, for example, Martha Stewart. Stewart committed illegal insider trading in 2001 when she sold stock in a biopharmaceutical company after receiving an unlawful tip. She dumped Stewart all of her 3928 securities.

Shortly after, ImClone stock fell by 60% due to the rejection of the company’s application for a key cancer drug. 

Stock Buyback Rules To Know

Buying back shares, as counterintuitive as it may seem, makes perfect sense sometimes. However, things can get taken too far, as in the scenario above. There are extensive regulations governing corporate share repurchases.

Follow Rule 10b-18

Stock Buyback Rules

Rewind to 1934, section 12 of the Securities Exchange Act of 1934, Rule 10b-18—Purchases of Certain Equity Securities by the Issuer and Others Act. The rule is designed so the company can’t make multiple trades through multiple brokers and try to pump up the stock’s price.

Just in December of last year, the SEC proposed changes to rule 10b-18. the proposed amendments would require an issuer to disclose a number of things:

  • the objective or rationale for the share repurchases
  •  the process or criteria used to determine the repurchase amounts 

The proposed rules would require an issuer to provide a new Form SR before the end of the first business day following the day the issuer executes a share repurchase.

Form SR would require disclosure identifying the class of securities purchased, the total amount purchased, the average price paid, as well as the aggregate total amount purchased on the open market in reliance on the safe harbor in Exchange Act Rule 10b-18 or pursuant to a plan that is intended to satisfy the affirmative defense conditions of Exchange Act Rule 10b5-1(c). The SEC’s end goal is to ensure transparency for all. 

Timing Of The Stock Buyback

Even if a board of directors authorizes the immediate launch of a buyback program, it doesn’t happen immediately. And in many instances, the CFO will delay the buyback to ensure they follow the law. 

Staying Out of Jail By Having a “Black Out” Period

To address the risk of insider trading, many companies give their broker a heads up. In other words, they let them know trading may need to be suspended. In fact, many companies apply a “blackout period .”

During this time, all trades—to corporate repurchases are forbidden. This is the same as they do for insider stock purchases by individuals. In many cases, a company may decide not to trade during a period that extends from 10 days before through two days after an earnings release.

Stock Buyback Rules Final Thoughts

The bottom line is this, share repurchases, stock buybacks, share buybacks, or whatever we decide to call them, are simply a tool. They are not inherently good or evil; it all depends on how they’re used. But it’s important to know the stock buyback rules.

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