Stock Buybacks: The Rules

Is your company planning to buy back publicly held stock? If so, it’s not alone. In 1998, U.S. corporations announced plans to buy a record-setting $220-billion worth of their own shares, according to Securities Data Co., Newark, New Jersey. But CPAs and other financial executives who administer repurchase programs can’t just pick up the phone and place an order with a broker to buy treasury stock, especially if they know that the company’s earnings will soar or that it will soon announce a strategic decision apt to be popular on Wall Street. They are insiders, and as such, face tough insider information rules. Here’s how to execute a buyback program at a good price with the SEC’s blessing.

Harvey J. Goldschmid, general counsel at the SEC, says that stock repurchases made by company managers with material inside information can disturb “the integrity of the markets.” (PHOTO BY: DENNIS BRACK/ BLACK STAR)

What is inside information exactly? That’s not easy to pin down—ask your company’s corporate counsel. But if the information hasn’t been disclosed publicly and you think the stock might move if it were, it probably qualifies. Financial executives routinely have early access to such information. To level the playing field, securities law requires publicly traded companies to disclose any material information about operations. What makes information “material”? That answer is not clear-cut either, but if it can affect earnings by 3% to 5% or more or can move the stock, it probably is. If a company acts on such information before it is released to the public, however—exercising a distinct advantage over other investors—it violates U.S. law.        

“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 went into the market knowing that the shares soon would double in value due to a discovery—without telling shareholders about the discovery. That creates a kind of unfairness that is traditionally considered fraudulent.”

Share-price manipulation has concerned regulators since the “Securities Exchange Act of 1934 attempted to prevent manipulation of the market by issuers, officers and directors,” says Susan M. Barnard, a securities-law attorney with Sullivan and Worcester, LLP, Boston. “Basically, the rules try to prevent a company—by virtue of going in and out of the market—from artificially inflating or deflating a stock’s price.”

Companies that violate insider-trading laws risk incurring a range of costly penalties. Goldschmid points out that the potential remedies run from criminal sanctions, which include prison terms of up to 10 years, to triple-disgorgement penalties, in which the SEC seeks three times the amount of money made by the misuse of inside information. Other shareholders also have standing to sue a violator.

WHY BUY BACK SHARES?

There are several reasons why companies have been buying back their stock at record rates. First, Wall Street loves stock repurchases. A stock repurchase reduces the number of shares outstanding. Accordingly, earnings divided by shares outstanding—earnings-per-share—go up. That increases the value of the stock for the remaining shareholders. Share repurchases are, in effect, an investment in the company’s own stock. At least in theory, management only repurchases stock if it expects to enhance shareholder value more that way than by using the cash for capital spending, acquisitions or dividend distributions—the latter of which would trigger taxes for the dividend recipients.

One of the most conspicuous reasons for the growth of such programs is to help offset the dilutive effects of generous stock compensation packages for employees, including stock options and stock contributions to 401(k) programs. Earnings are “diluted” when the number of shares outstanding increases, reducing per-share earnings. As successful companies issue new shares to reward their employees, the other shareholders’ per-share earnings are, inevitably, diluted.

“Our share repurchase program has two elements to it,” says James E. Duffy, CPA and chief financial officer at HS Resources, Inc., an oil and gas exploration and production company in San Francisco, which recently announced a $5 million expansion of an existing repurchase plan. “The first element is that we repurchase shares during the course of the year for making contributions to our 401(k) plan and other employee programs.” Duffy also sees the repurchases as an investment in the company’s own assets. “We also view share repurchases over time as another way for us to essentially buy our oil and gas reserves cheaply, so we take advantage of those opportunities when we can.” In other words, if the company allocates its oil and gas reserves on a per share basis, it can acquire more reserves for a dollar invested in its own stock than it can by buying them elsewhere.

TIMING STOCK PURCHASES

Even if a board of directors authorizes the immediate launch of a buyback program, the rules covering the timing of purchases around major developments within the company may cause the CFO to delay implementing it. “We advise the company not to conduct a program at all if there is any material inside information that the company is aware of that has not been publicly disclosed,” says Jayne M. Donegan, a corporate and securities-law attorney with Brown, Rudnick, Freed & Gesmer in Providence, Rhode Island. “For example, if the company is in merger negotiations or it knows the earnings but those earnings haven’t been released, the company should not be out purchasing its stock.”

Jayne M. Donegan, a corporate and securities-law attorney with Brown, Rudnick, Freed & Gesmer, says that compliance with rule 10b-18 is a good defense against charges of market manipulation. (PHOTO BY: PETER SILVIA/ BLACK STAR)

To address potential insider trading, many companies inform their brokers that they may be required to suspend on short notice purchases authorized as part of an ongoing repurchase program. In fact, many companies apply the same “blackout period”—forbidding all trades—to corporate repurchases as they do for insider stock purchases by individuals. For example, a company may decide not to trade during a period that extends from 10 days before through two days after any earnings release.

Assuming no pending developments prevent a buyback and the company’s legal counsel gives its blessing, the next step for the executive administering the program is to get board authorization for it. That authorization should state both a dollar or share purchase limit and a time frame—for example; $5 million over one year, 3% of shares outstanding over the next six months or a half million shares before year-end. After the board makes its decision, the company should issue a press release detailing the program.

FOLLOW RULE 10b-18

Things start to get tricky at this stage because of the extensive regulations governing corporate share repurchases. The safest course of action for CPAs or others administering a buyback is to follow the guidelines found in the 1934 act’s Rule 10b-18—Purchases of Certain Equity Securities by the Issuer and Others. Technically, Rule 10b-18 provides a safe harbor only for repurchases of common stock. In practice, it is often used as a guideline for repurchases of other securities as well.

Even though compliance with Rule 10b-18 isn’t mandatory, it does reduce the potential for error in executing a buyback. “If you comply with Rule 10b-18, you have a pretty good shot at defending yourself if anyone claims you were manipulating the market,” Barnard points out. “If you don’t comply, it doesn’t mean that you have engaged in a securities law violation, but it doesn’t give you the same level of comfort as if you had complied.”

Susan M. Barnard, a securities-law attorney at Sullivan and Worcester, LLP, says that CPAs in business and industry should ensure that their company has an insider trading policy and that it adheres to it. (PHOTO BY: RICK FRIEDMAN/BLACK STAR)

Donegan says, “The rule is actually fairly restrictive. It is designed so the company can’t make multiple trades through multiple brokers and try to pump up the stock’s price.” These are the rules under 10b-18:

• During any one day, a company—together with affiliated purchasers (such as individuals involved in the decision to buy in stock)—can purchase or make bids through only one broker or dealer. For instance, the CFO cannot buy stock for his own account through a different broker.
• Neither the company nor affiliated purchasers can do the opening trade on that market that day; they are also forbidden from trading during the last half hour before the market’s close.
• The company and affiliated purchasers can’t bid at or settle at a purchase price that exceeds the highest current independent bid quote or the last independent sales price, whichever is higher.

In addition to the multiple broker, price and time restrictions, complex guidelines cap the allowable trading volume.

• On any single trading day, the company can’t purchase more than the greater of either one round lot (100 shares) or the number of round lots that is closest to 25% of the company’s stock’s average daily trading volume in the four previous calendar weeks.

The volume restriction in the safe harbor allows an exception for block purchases. That can increase a program’s flexibility significantly. To qualify as a block, the stock purchase must have at least one of the following characteristics:

• A price of $200,000 or more.
• At least 5,000 shares and a price of $50,000 or more.
• At least 20,000 shares and 150% of the stock’s average daily trading volume (excluding block trades) for the preceding four calendar weeks.

“So if there is a big chunk of shares out there—and often these are privately negotiated trades that are not on the market—that trade isn’t included in the volume restriction,” Donegan says.” The idea is that there isn’t the opportunity for market manipulation when the company is buying a large block back from one stockholder.” In fact, if such a large block were to be thrown into the open market, it would probably cause a supplydemand imbalance, forcing the stock price down. That would not be good for the other investors.

CPAs should ensure that their company has “a firm, and regularly adhered to, insider trading policy about which employees, officers and directors and others have been informed, and about which they are regularly updated and reminded,” Barnard says. The corporate repurchase program should conform to that insider trading policy. At most companies, that means that employees must clear purchases of the company’s stock in advance through the legal department. Accordingly, any executive with potential inside information should inform the legal department that it should veto any repurchases.

THE BROKER’S ROLE

Rule 10b-18 is complex. Accordingly, the company’s brokerage firm should have the legal and trading expertise needed to stay within the safe harbor boundaries without sacrificing execution—the ability to get a good price for stock purchased for the treasury.

According to the CPAs, CFOs and attorneys interviewed for this article, most brokerage firms know the rules and have no problem complying with them. Roy Liljebeck, CFO of Airborne Freight Corp., Seattle, reports solid performance from his brokers. The company, which recently completed a 2-million-share repurchase and has board authorization to buy another 2 million shares, trades on the New York Stock Exchange and works with multiple brokers, giving some business to each.

Liljebeck rotates the buyback assignments among the brokerage firms that issue research reports on his company. Execution quality is his primary concern. To track it he checks the prices each broker gets for him against a list of all block trades over 5,000 shares. The NYSE provides him with that list each trading day. “You’re looking to see if they always traded on the high end of the day,” he says. That would be a problem. Good execution would be on the low end. “If I looked at that list, compared it to the execution report and saw that we were trading on the high tick every time, I’d think we got some bad execution.”

Many brokerage firms, particularly the larger organizations, have separate departments in place for Rule 10b-18 trading and compliance. Robert Leonard is the managing director in charge of Salomon Smith Barney’s seven-member Special Equity Transactions Group, which executes the company’s legally sensitive equity trades, including repurchases. According to Leonard, it’s easy to comply with the regulations. “Generally, everyone is up to speed on Rule 10b-18 and how to buy back stock within the confines of the rules.”

That may be true for most sophisticated companies that have repurchased their own shares on many occasions. But there have been a lot of IPOs lately, and the first repurchase can be daunting. That’s a good reason for a company to use a well-established broker if it can.

“So far we’ve worked exclusively with one firm. It has a group that specializes in these transactions,” says HS Resources’ Duffy. “Their internal systems, which we evaluated when we first set up the relationship, have all the built-in controls needed to prevent executional problems. However, we do require an indemnification under the stock repurchase agreement that protects us against any trading violations under 10b-18.”

Steven L. Dutro, CPA, is the CFO of KLLM Transport Services, Inc. That company’s stock is thinly traded, so he has little choice—he used the company’s market maker as the broker for a buyback. (PHOTO BY: JACKSON HILL/ BLACK STAR)

Smaller companies that do not trade on an exchange face a narrower selection of brokers than larger, exchange-traded firms do. The board of KLLM Transport Services, Inc., in Jackson, Mississippi, recently authorized a repurchase of about 3% of its outstanding shares. Steven L. Dutro, CPA and CFO of the company, did not need an extensive search for a brokerage firm. Only a couple were willing to trade the stock at all. “I didn’t choose a market maker—it selected us. Our stock is thinly traded and there aren’t many market makers, which makes the selection process simpler for us than for many other public companies.” Among other duties, a broker making a market in a stock is responsible for smoothing out supply/demand imbalances by buying stock for its own account when too much comes on the market, and selling stock from its own account when too little is available. That involves assuming some risk. In return, a market maker gets to keep the small spread between the bid and asked prices.

INDEMNIFICATION

If the CFO, CPA or other supervisor of the repurchase program has doubts about a broker’s Rule 10b-18 competence, the company’s legal counsel should be asked to bring him or her up to speed, or the company should use another broker. The company should establish a procedure for reviewing the broker’s performance, routinely checking for compliance with all 10b-18 guidelines. CPAs are good candidates for setting up such control procedures. Donegan reports a case where a month after the repurchase was completed the company’s CFO spotted trades that exceeded volume limits. The trading excess was small and did not cause any problems with the SEC, but the brokerage firm had been ignorant of the limits and had not followed Rule 10b-18 guidelines. Since Rule 10b-18 is a safe harbor guideline and does not carry the force of law, such violations do not have to be reported to the SEC. Nonetheless, no company would want to find itself outside the safe harbor.

“It’s important for a CFO to be sure that the brokerage firm is educated about the rules,” Donegan says. “The CFO might consider putting something in writing to the broker, stating that the repurchase program must be conducted in accordance with Rule 10b-18 and these are the limitations.” While brokerage firms should know and be responsible for complying with Rule 10b-18 provisions, it would be rash to presume that all individuals at all brokerage firms are equally knowledgeable.

Leonard thinks it is a good idea to have a formal agreement between a company and its brokers. “Usually when we are working on an exclusive basis or as part of a rotation, companies like to have an agreement letter, which we call a ’10b-18 wraparound letter.’ In it, we state we will adhere to all the conditions of the rule. We list the names of the people responsible on our end and at the company, and ask them to sign the letter if it meets their understanding.” The exhibit above lists the essential points such a letter should include.

INTERNAL COORDINATION

To comply with Rule 10b-18 guidelines, companies need to aggregate corporate stock purchases with those of any “affiliated purchasers.” This applies to all 10b-18 restrictions, not just the volume limits. As a general rule, “affiliated purchasers” include directors and senior officers who participate in the buyback decision. Repurchase plan administrators are not required to include purchases from the company made under a stock option or incentive compensation plan, or purchases made in the market by agents such as retirement and dividend reinvestment plan trustees. To prevent problems, companies should require members of the affiliated group to notify the company whenever they plan to buy the company’s stock.

In spite of the complex repurchase rules, the sources interviewed for this article have seen very few instances of noncompliance. By providing adequate disclosure and retaining competent brokers, most firms seem to have no unusual difficulty staying within the law.

“It’s pretty straightforward,” says Duffy. “Obviously, there are rules that must be adhered to closely. So it’s a combination of corporate timing, legal availability and proper execution. Sometimes it means you don’t get to buy shares you’d like to buy, but that’s part of the discipline.”