Ask the experts: Why are share buybacks under the spotlight?

Jonathan Beastall, a senior adviser to Pinsent Masons corporate practice, explains why a company might buy back its shares, and the issues raised by this 

What is a share buyback?A public listed company can buy back its own shares if it has shareholder approval. Most public companies will seek approval at their AGM. Investment Association guidelines say if a company is going to buy back its shares, it should limit it to 10% of capital in any one year and that the approval should be given by a 75% majority.

Once purchased, the company has the choice of keeping the shares in treasury or cancelling them. Keeping them in treasury can help liquidity in the market, reduce the cost of issuing shares in the future, or satisfy share option scheme arrangements. But it’s more common for companies to cancel shares because reducing the amount of shares in issue can enhance certain performance measures. Earnings per share is the obvious one.
Why do companies buy back their shares?Mainly to return capital to shareholders. To buy back its shares, a public company has to use its distributable profits. In that regard, it is exactly the same as if the company pays a dividend. 

But there can be several other reasons. Alongside enhancing certain performance measures, as mentioned, buying back shares can be a useful tool for making sure the capital of a company is being used efficiently. It’s often said that equity is expensive because of the expected return on the riskiest level of capital whereas right now debt is cheap. If a company could have more debt and less equity, that should result in the return on equity in the business being enhanced. So, shares are bought back to reduce the amount of equity and debt is increased to finance that buyback.

Share buybacks can also reduce the number of owners, giving shareholders that remain a greater incentive to scrutinise what management is doing, because they have a higher percentage of the share capital. So it can be an encouragement to more active stewardship on the part of shareholders.
How do investors benefit from share buybacks?There are tax advantages to some shareholders in receiving payments in respect of the capital of their shares, rather than receiving dividends, which are usually treated as income in shareholders’ hands. Share buybacks, by returning surplus cash to shareholders, empower investors to make their own financial choices in deciding where to allocate their capital and where they want to invest. Shareholders do not like having their capital trapped in the bank accounts of investee companies when they could get better returns elsewhere.
What are the concerns about share buybacks?The commonly held concern is that they can be used to artifically enhance performance and that in turn is important because quite a lot of executive remuneration arrangements can be tied to whether certain performance targets are met. 

There can also be a concern that company directors are not always the best judges of when it is the right time to buy shares back. They are employed because they are good at running the businesses of which they are directors, but they are not necessarily good at being investment managers or determining when the market is right or wrong about the value of their company. 

There is a view that buybacks crowd out other investment decisions. So companies engaging in buybacks don’t adequately invest in their underlying businesses. That’s a bit dangerous in terms of argument because a company buying back its shares would regard the funds as surplus to requirements and not for use in the business, but that is nonetheless a view that is out there. 

I also mentioned that equity is expensive and debt is cheap. In increasing the level of debt in a company to enable it to buy back its own shares, there is a possibility that you make it a bit more fragile in being able to weather external events. 
What are the ethical issues raised by share buybacks?About the expert
Jonathan Beastall is a senior adviser to Pinsent Masons corporate practice. He has more than 30 years’ experience of advising clients on company law, IPOs, equity issues, listing rules and corporate compliance, M&A and reorganisations.
I don’t think there are ethical issues as such, but I think a board does have to take into account a number of different factors before it decides whether using the company’s resources to buy back its shares is the right thing to do in the circumstances. That will probably become even more relevant because there is a lot of focus at the moment around the general duty under Section 172 of the Companies Act. This requires directors to act in good faith to promote the success of the company and to take into account different stakeholder views on what they’re doing in discharging that duty.
The UK government has commissioned research into share buybacks, with a view to taking action to prevent them from being abused. Findings are due in summer 2018. What can we expect?None of us know what this research is going to conclude. If it turns over some stones and finds things it doesn’t like, there could be a need for share buybacks to be revisited and either refined or defended. I think companies are going to have to keep an eye open for the publication of this research and put themselves in a position to be able to answer comments or questions about how it affects them. It’s very topical at the moment.

This article was originally published in the Q2 2018 print edition of The Review. The print edition is available to all members who opt in to receive it, except student members. All eligible members who would like to receive future editions in the post should log in to MyCISI, click on My Account/Communications and set their preference to 'Yes'. 
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Published: 25 Jun 2018
  • Capital Markets & Corporate Finance
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