Monday, November 13, 2006

Share Buybacks and D & O Risk

One of the most noteworthy corporate phenomena of recent months has been the increasing prevalence of companies buying back their own shares. According to an article in the New York Times (here, subscription required), the S & P 500 companies are on a pace to repurchase more than $435 billion worth of their own shares this year, compared with $349 billion in 2005 and only $131 billion in 2003. The conventional wisdom is that share buybacks help shareholders by reducing the supply of shares, thereby driving up the price. But buybacks only make economic sense of the share purchase is the most advantageous alternative for the cash used – that is, it makes sense if the shares are undervalued compared to other assets. Otherwise, shareholders are better served by a dividend payment. It strains common sense to think that all of the shares of all the companies repurchasing their own shares right now are undervalued relative to other assets, particularly since share prices generally have been rising -- which raises the question whether there may be more behind the recent wave of share buybacks than attempted maximization of shareholder interests.

Warren Buffett flagged the issue in his letter to shareholders in the 2005 Berkshire Hathaway Annual Report (here), when he described the share repurchase practices at a fictitious company, Stagnant, Inc. In Buffett’s story, Stagnant’s CEO, Fred Futile, gets rich simply by using buybacks to boost his company’s earnings per share (EPS), despite being unable to grow the company’s net income.

The issue Buffett raise was explored further in a November 12, 2006 New York Times article entitled “Why Buybacks Aren’t Always Good News” (here, subscription required), which examined whether share repurchases are being used to boost executive compensation. The article reports research conducted jointly by the Center for Financial Research & Analysis and the Corporate Library. The researchers looked of companies that engaged in share repurchases while compensating executives based on EPS, while the companies were experiencing negative cash flows for the last two years. The study found 78 companies in the S & P 500 that met these criteria, including three companies the experienced negative cash flow for the last three years. The researchers also found that none of these companies discussed in their proxies the impact of the buyback program on executive compensation.

An additional share repurchase practice that may be even greater concern is the practice of management selling their shares at the same time the company is conducting a share buyback program. An article in the November 2006 issue of CFO Magazine entitled “Can You Have Your Stock and Sell It, Too?” (here) questions whether management sales of company shares at the same time as the companies were conducting share repurchases represent a conflict of interest. The article reports research conducting by Audit Integrity, which looked for companies with market capitalizations over $100 million and that had high levels of both stock buybacks and insider selling. The research identified 16 companies with these characteristics.

None of this has been lost on the plaintiffs’ bar. The CFO Magazine article quotes Bill Lerach of the Lerach, Coughlin firm as saying:
In our view, there is an inherent conflict of interest when insiders are using the stockholders’ money to buy back shares on the theory that they are undervalued, and at the same time are unloading their own shares….We believe it to be an inherently bad practice. Certainly, when we evaluate whether to bring suit against insiders for securities fraud, it’s something we look for, and when we see it we view it to be very incriminatory.
Lerach also is quoted as saying that his is putting the finishing touches on a lawsuit he plans to file against “one of the most high-profile companies in the United States,” along with its CEO, over issues relating to its buyback program.

Because conventional wisdom views share repurchases as benign, or at least as a standard part of the management tool kit, they have at least historically not been questioned. But there really have never been share buybacks anywhere near the current level, and recent media scrutiny may raise concerns with the practice, particularly where executives are being compensated on a EPS basis. Companies whose executives are selling shares while their companies are buying shares back may face particular scrutiny, and indeed if Lerach’s statements are credited, may face a greater possibility of D & O claims. Certainly, a company whose executives are selling shares will be hard pressed to argue that its shares are undervalued relative to other assets, which undermines the theoretical basis for a buyback in the first place.

Given the growing prevalence of share repurchases, this area may represent an area of heightened scrutiny and potentially increased D & O risk in the months ahead.

For an interesting discussion critical of the New York Times referenced above, refer to Professor Larry Ribstein's Ideoblog, here.

Options Backdating Contagion?: There has been extensive media coverage discussing the potential impact of the options backdating scandals on the insurance industry (for example, see this recent San Francisco Chronicle article here). But there has been relatively little discussion whether the scandal could affect other kinds of companies, other than insurers, as a result of investigations companies under investigation.

At least one bank is at least raising the question whether its customers’ options woes could affect its business. In its 3Q06 10-Q (here), SVB Financial Group, the bank holding company for Silicon Valley Bank, included the following risk factor:
Many technology companies have been subject to scrutiny concerning their historical stock option grant activities which could negatively impact our client borrower market.

In recent periods, there have been several reports in the media questioning public company stock option practices, as well as a number of formal and informal regulatory investigations and other actions in connection with the historical stock option grant activities of certain companies. Many of our client borrowers utilize stock options in their employee compensation programs and, as such, could be adversely affected by these developments. Any increase in litigation, investigations or other regulatory actions which adversely affect companies that grant employee stock options, or that adversely affect the technology sector more generally, could adversely affect our client borrowers and potential client borrowers, and therefore could result in a material adverse impact on our results of operations.

SVB also stated that due to publicity surrounding the options backdating scandal, it had voluntarily launched an internal review of its own options practices. Its review is not yet complete and the company has not released any other details about its review.

A November 13, 2006 CFO.com article discussing SVB Financial Group’s options related disclosures can be found here.

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