Regulators and policymakers are under pressure from various political and industry players across the capital markets, not only here in the UK, but in Europe, the US and as far away as Japan.

They are in pursuit of ways to enhance the various jurisdictional competitiveness of markets to attract new growth companies to list and new capital to invest.

The UK has two high-profile mouth pieces, in Julia Hoggett, the London Stock Exchange’s CEO, and Latham’s Mark Austin, who are both making positive noises. These CMIT members are upbeat about the prospects of the UK and continue to craft the narrative following many years of reviews and reforms that have been helping the UK to arrive at this point, “match fit” for the future.

As part of this reform process, the FCA just announced their new listing rules following tier review process. There has been some feedback focused on the very narrow topic relating to the efficiency of share buyback executions. Why?

Trillions at stake

Share buybacks are huge, and their popularity is growing rapidly. Over the past two years, UK listed companies have returned more than £110bn to shareholders via this process; globally, this number is a little over £2trn. By comparison, in the same two-year period, IPOs in the UK totalled about £2.5bn. If there are any gains to be made in the efficiency of executing share buybacks, then this should be worth exploring.

Last year, Brooke Masters wrote in the Financial Times about Royal Mail’s paying a fee of 8.5% to execute their 2021-22 buyback. In a world where execution fees for buying shares are measured in basis points (one hundredth of 1%), on the surface 8.5% seems grossly inefficient. This surface is now being scratched. Below the surface and behind information barriers, it appears these inefficiencies are a global phenomenon within share buyback executions.

Part of the problem lies with the execution products sold by our investment banks, to help issuers repurchase their shares. In the UK and Europe, it is illegal (market abuse) for a company to buy its own shares unless a very prescriptive set of processes and procedures are followed. One very specific part is that the “sole purpose” for the buyback needs to be one of three reasons. The most frequently chosen exemption for these larger share buybacks is to reduce the issuer’s share capital.

What does “sole purpose” mean within the context of the execution of a buyback? When you talk to a lawyer, it is likely their first reference will be to show that there is a commercial reason, rather than, say, a tax reason for the company to elect to do a buyback. But talk to a trader, and the meaning of “sole purpose” is very different indeed. Given this sole purpose rule is used as an exemption to market abuse, you can guess what traders might be thinking.

Shareholder gains

When a company buys back shares, they are buying those shares from one set of shareholders, on behalf of those shareholders who remain. The sellers receive the money; the remaining shareholders receive an increase in ownership of the company. The size of this increase in ownership is directly dependent on how many shares are repurchased.

Do all execution strategies align with the “sole purpose” of reducing the share capital? After all, buying five shares or five million shares both reduce the share capital. The critical question a trader asks is what the execution strategy is optimising for?

The number of shares that any share buyback execution will deliver is a combination of the future share price path, and what that execution strategy is optimising for.

Maybe a few charts tell the story better. In the graphs above, the blue bars represent the value of shares repurchased by the corporate each day. The white dotted lines are the daily share prices. The broker dramatically increases the rate of repurchasing immediately post the share price going ex-dividend.

You do not need to be a trader to tell that whatever execution strategy is being used for these buybacks, they are clearly not optimising for the number of shares purchased. A closer look at each issuer’s disclosure statements will tell you that they have both entered into a non-discretionary agreement with their broker, and the broker will make all the trading decisions independently from the issuer. All eyes now turn to the suitability of these execution products sold by the investment banks/brokers and how they are incentivised.

Is it legal?

There are two primary concerns for a board in these situations. The first is around the legality of the buyback’s implementation. When the lawyers have quickly searched for the other possible meanings of “sole purpose”, will their conclusion change? And will the regulators agree? The second concern is how to respond when shareholders come looking for answers to explain these unusual trading patterns, which may have a had a direct impact on the increase in ownership stakes?

For the banks, on the other hand, they all know how to design execution strategies to optimise for the number of shares purchased—they sell algorithms to investors that solve for this challenge all the time. Indeed, these banks use these very same algorithms to manage their own risks, too. These plain vanilla execution products are very low margin for banks and brokers.

The average margins for execution products sold to issuers to solve for share buybacks, are predominately principal-based solutions with embedded optionality. Their margin profile is very different to those plain vanilla products sold to investors, yet both investors and issuers are essentially trying to solve for the same problem sets. Clearly one of these sets of products is unsuitable.

The breadth and materiality of any potential issues are clearly a factor. A 2019 survey, across 145 UK and EU companies, suggested that 79% of issuers have historically preferred a set of execution strategies which may require further scrutiny.

Ultimately it is the boards and executive office of our issuers to whom shareholders and regulators will turn to if hidden problems are found within current buyback execution processes. Might boards be better served through asking the right questions about how, and under what conditions, any share buybacks are executed?

A prominent city lawyer once said to me, “Mike, I speak from experience. If there is one thing a company does not want to have, it is an illegal share buyback or dividend.” Boards had best carry out some “sole searching” then.

Michael Seigne is the founder of consultancy Candor Partners