Tuesday, January 4, 2011

Market Regulations Reducing Productivity

As recently as three or four decades ago, companies in the US were wary of buying back their own shares because this could be considered illegal price manipulation. In 1982, the SEC enacted a rule that gives companies repurchasing shares safe harbour from prosecution for price manipulation, and this has been a major contributor to the growth of buybacks. But regulations restricting the flow of capital continue to hamper the productive flow of capital, as the following are among the conditions for safe harbour protection, as set forth by the SEC in Rule 10b-18:

- No repurchase is made at a price exceeding the highest current independent bid
price or the last independent sale price, whichever is higher.
- Non-block repurchase volume does not exceed 25% of the average daily trading volume for the preceding four calendar weeks

Clearly, these could be major deterrents for small companies looking to repurchase shares. Fortunately, these are not requirements; they only protect the company from charges of price manipulation. Still, these conditions likely deter many small companies from using this option for returning cash to shareholders.

Furthermore, many of the large companies listed on US exchanges are also listed on exchanges in other countries. The regulations enforcing buybacks in most other countries are much more restrictive, and therefore the US issue can suffer as a result.

For example, consider Research In Motion, a company previously discussed as a potential value purchase. RIM is listed on both Canadian and US exchanges. As its stock fell to the $40 range in the summer, management was furiously buying back shares, but had to stop too soon: Canadian-listed companies can only buy back 10% of their shares on the open market in a year. As RIM's shares recovered to $60, shareholders were not rewarded from bargain buybacks as much as they should have been; RIM now sits on $2.5 billion of cash, but management is handcuffed from buying back any more shares until July of 2011!

This issue also came up a few months ago as the dual-listed (in both Canada and the US) Quest Capital was prevented from buying back shares when it traded at a large discount to its book value, which was made up of mostly current assets. While Quest's price did eventually trade up to the company's book value, the per-share book value (and therefore, the subsequent price appreciation) would have been higher had management been allowed to buy back more shares than the regulations stipulated.

For a table outlining the buyback restrictions imposed by various countries on their exchange-listed stocks, see Table 1 at the bottom of the following paper, Survey On Open Market Purchase Regulations.

Governments around the world currently lament the large cash accounts carried on corporate balance sheets, forcing governments to spend and/or print money to keep capital flowing. At the same time, however, government regulations are keeping corporations from buying back shares, which would send cash to more productive uses and reduce the onus on governments to stabilize capital markets.

Disclosure: Author has a long position in shares of RIMM

2 comments:

Paul said...

I really like the last paragraph. It's something I haven't really thought about.

"At the same time, however, government regulations are keeping corporations from buying back shares, which would send cash to more productive uses and reduce the onus on governments to stabilize capital markets."

As always, thanks for sharing!

Mike said...

I didn't realize that. Wow, great article. Thanks!!

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