Locke Lord QuickStudy: Buybacks: How Companies Can Benefit From Undervalued Stock

Locke Lord LLP
June 2, 2020

Corporate stock buybacks have been prevalent in recent years. However, due to COVID-19 and ‎market volatility, many companies, because they are focused on liquidity and balance sheet ‎strength, have suspended or terminated existing stock buyback programs. Despite falling out of ‎favor, analysts estimate that companies will spend hundreds of billions of dollars on buyback ‎programs in 2020. As companies grapple with COVID-19 and economic uncertainties, the market ‎will present opportunities for those companies with strong balance sheets to implement stock ‎buyback programs and make repurchases. ‎

Important considerations when preparing for a stock buyback include:‎

  • Relevant law of the state of incorporation;‎
  • Organizational documents; ‎
  • Credit and other agreements that may restrict the ability to repurchase outstanding shares;‎
  • Stock exchange requirements; and
  • Potential tax and accounting treatment of repurchases.‎

Buybacks must comply with the antifraud and anti-manipulation rules under the ‎Securities Exchange Act of 1934 (the “Exchange Act”) and federal securities law disclosure ‎requirements. For example, a company may have to disclose non-public information before ‎repurchasing its shares. In addition, a company may need to comply with Regulation FD ‎prohibiting selective disclosures of material non-public information. A company typically will ‎disclose its adoption of a stock repurchase program prior to commencement of repurchases. ‎Depending on timing, the announcement can be made by means of a press release or Exchange ‎Act filing. The disclosure obligations do not end upon the repurchase of the shares; details of ‎share repurchases must be disclosed pursuant to Item 703 of Regulation S-K in a company’s next ‎periodic report. ‎

The new stimulus and government lending programs under the CARES Act can limit ‎buybacks. With limited exceptions, businesses that receive funds are prohibited from ‎repurchasing company stock for a period ending 12 months after the loan or guarantee is repaid.‎

When contemplating a buyback, companies should evaluate the impact of repurchases on ‎the cash position of the company and its projected capital needs.  They should consider other ‎uses for their cash, such as potential alternative investments and the need to preserve liquidity. ‎Well-positioned companies may borrow funds to take advantage of current market prices for ‎their shares. Once the decision is made to proceed, a company’s board of directors typically ‎authorizes and approves a stock buyback plan. The board should consider and document its ‎attention to stockholders’ best interests and proper discharge of fiduciary duties, with a particular ‎focus on the company’s liquidity and future cash needs, the effect of the buyback on its ‎capitalization and the reaction of investors, understanding that there are various groups that are ‎critical of company buybacks.‎

A buyback can be accomplished in several ways: open market purchases; privately ‎negotiated transactions; accelerated stock repurchase agreements; and tender offers. ‎

Open Market Stock Buybacks

The most common buyback plan involves purchasing shares in the open market. Rule 10b-‎‎18 under the Exchange Act provides a non-exclusive safe harbor from violation of anti-‎manipulation rules. To benefit from the rule’s protections, the buyback must meet manner, time, ‎volume, and price restrictions, designed to minimize the effect of the repurchases on the price of ‎the shares.  ‎

Open market buyback programs involve a broker-dealer buying on behalf of the company ‎in ordinary trading transactions. The company does not have to offer premium pricing, nor does ‎the company have any obligation to complete the repurchase program. The open market ‎repurchase method gives companies the most flexibility compared to other types of buyback ‎plans. Conducting buybacks in the open market can be cost-effective, limiting repurchases to ‎avoid driving price increases while taking advantage of lower stock values. A company can ‎decide whether and when to buy back shares and can choose to terminate a buyback program. ‎

Companies often comply with Rule 10b5-1 when establishing a buyback program.  That ‎allows them to continue making repurchases despite being in possession of material non-public ‎information. To do so, the company adopts the plan at a time when there is no undisclosed ‎material non-public information, and the repurchases are made based on a formula or set of ‎advance instructions to the broker-dealer, so the company loses some degree of control over the ‎timing and amount of the buybacks. ‎

Privately Negotiated Buybacks

The company may approach one or more large stockholders to negotiate a repurchase of ‎shares at the market price or at a premium. Using this method can allow the company to ‎repurchase a sizeable block at one time. The number of stockholders the company may approach ‎is limited to avoid the repurchases being considered a tender offer. Like all repurchase programs, ‎privately negotiated transactions are subject to Rule 10b-5’s prohibition on repurchases made ‎while in possession of material non-public information and the need to comply with Regulation ‎FD. It may be possible to use “big boy” letters with sophisticated sellers who disclaim reliance on ‎the company for information in making their decision to sell so as to avoid disclosing additional ‎information. If material non-public information might be revealed to potential selling ‎stockholders, wall-crossing procedures and confidentiality agreements could be used while ‎negotiations are on-going.‎

A variation of the privately negotiated buyback is sometimes used in connection with the ‎issuance of convertible securities by the company. Because some convertible securities buyers ‎short the common stock at the time of purchasing the convertible securities, a company can ‎undertake a simultaneous share repurchase in order to alleviate downward pressure on the stock ‎price caused by the issuance of the convertible securities. ‎

Accelerated Stock Repurchase Agreements

In an accelerated stock repurchase agreement (“ASR”), the company enters into a ‎forward contract with an investment bank for the purchase of its shares. The investment bank ‎borrows shares from existing stockholders and delivers those shares to the company. The ‎investment bank later satisfies its obligation to return the borrowed shares by purchasing shares in ‎the open market during a pre-agreed time period. An ASR allows a company to retire shares ‎upfront upon delivery from the investment bank, while purchases of shares in the market take ‎place over time. ASRs can be tailored through the use of collars, caps, and knock-out days to ‎limit the company’s exposure to future increases in stock price and to improve the buyback’s ‎pricing. ‎

While market purchases by the investment bank under an ASR do not fall within Rule ‎‎10b-18’s safe harbor, they are typically structured to meet the requirements of the rule. Also, ‎ASRs are most often set up as Rule 10b5-1 plans, which provides the protective benefits referred ‎to above.‎

Tender Offers

Another way for a company to repurchase shares is an issuer self-tender. A tender offer ‎may be structured as a fixed price tender offer or a modified Dutch auction tender offer. In a ‎modified Dutch auction tender offer, the company offers to repurchase a fixed maximum number ‎of shares within an identified (approximately 15%) range of prices. In a fixed price tender offer, ‎a company makes an offer to stockholders to purchase the company’s shares on a fixed date and ‎at a fixed price. The price of the tender offer almost always includes a premium over the current ‎market price. The stockholders who are interested in participating inform the company of the ‎number of shares they are willing to sell. If a company intends to repurchase a significant portion ‎of its stock, it may be able to complete the tender offer transaction more quickly than an open ‎market buyback program. Choosing a tender offer allows for greater participation by ‎stockholders compared to open market and privately negotiated buybacks.‎

Tender offers by a company for its own shares must comply with Rule 13e-4 under the ‎Exchange Act. For example, the offer must remain open for at least 20 business days, and the ‎company cannot repurchase any shares outside of the tender offer or for 10 business days after ‎completion of the tender offer. In addition, companies must file with the SEC a tender offer ‎statement on Schedule TO, as well as written communications relating to the tender offer.‎

Key Takeaways

Stock buybacks are an effective way companies can choose to return capital to ‎stockholders and increase confidence in a company during times of financial hardship. In ‎uncertain and volatile markets, companies with the financial resources to invest may have an ‎opportunity to buy back stock at an advantageous price.‎

Your regular Locke Lord contact and any of the authors can discuss these matters with ‎you. Please visit our COVID-19 Resource Center‎ ‎often for up-to-date information to help you ‎stay informed of the legal issues related to the current market.‎