The common practice of share buybacks is on the UK government’s agenda. In late January the department for business, energy and industrial strategy (BEIS) announced that it is engaging PwC to conduct a study on potential abuses of buybacks as a new initiative in the broad package of corporate governance reforms that was announced by the government in August last year.
A share buyback is not intrinsically flawed, nor is it a complex mechanism of financial engineering; it simply amounts to a company purchasing its own stock on the open market.
This can be a legitimate tool for companies to manage their capital structure and capital allocation, especially in cases when a company may lack suitable investment opportunities, have surplus liquidity or where management may have reason to believe that a company’s share price is undervalued.
While BEIS is aware of the legitimate uses of buybacks, its study will focus on the dark side: how buybacks might be abused, in particular with regard to their impact on executive remuneration.
One of the potential flaws of buybacks is that they can flatter company performance metrics without any fundamental change in the company’s underlying financial performance.
For example, earnings-per-share, or return-on-equity metrics, can effectively be gamed by reducing the number of shares or equity base. If these metrics are influencing bonus or incentive-plan payouts, there may be an incentive for buyback manipulations to trigger pay grants.
Or, they can actually increase financial risk, to the extent that a company may raise debt or cut back the level of equity capital below prudent measures.
In cases of abuse, or when simply unwise, the practice of buybacks is not only a concern for governments, but also for company investors and stakeholders as a matter of corporate governance.
A board is elected by its shareholders to ensure that the company is appropriately governed, and the directors’ care of duty extends to how and why buybacks are employed—and how they impact a company’s own long-term success.
Minority shareholders, both institutional and retail, will expect a company’s independent non-executive directors to both understand and guard against areas of potential abuse of buybacks where the results might cause the company to take undue risks, or providing asymmetrical (and often short-term) benefits to company executive managers or other insiders.
Questions to consider
Investors should expect company boards to consider the following questions:
• What is the objective of buyouts, and what role do they play in capital management? There should be a clear understanding of the need to retain capital in the business and why buybacks are a better source of return for all shareholders than dividends.
• Who benefits from these transactions? Do some benefit more than others? In particular it is important to understand the extent to which performance metrics relating to executive pay can be influenced by buybacks.
• What are the costs? Crowding out investment projects with longer-term payouts or impacting negatively the company’s balance sheet or credit quality?
• Do investors understand the capital allocation policy? Is it publicly articulated?
• Did the board discuss the price at which buybacks were made? How is an appropriate price agreed?
As a matter of investor stewardship, the question of buybacks also requires diligence by a company’s investors to monitor companies, engage and vote on capital allocation, and to ensure they have a clear understanding of the buyback approach and the capital structure more generally.
Finally, it is of note that buybacks do not feature, at least as yet, in the current UK Corporate Governance Code nor the UK Stewardship Code.
Depending on its conclusions, however, the BEIS study could lead to future considerations of buybacks in both company governance and investor stewardship codes.
A starting point on promoting a healthy discipline on buyback abuses may lie in the area of company disclosure.
A statement of company policy on capital allocation, including the use of buybacks, could serve as a useful way for investors, stakeholders and company directors to better understand—and ultimately govern—how a company manages its balance sheet and capital structure for sustainable success.
George Dallas is policy director at the International Corporate Governance Network.