Increased equity market volatility provides issuers with opportunities to repurchase shares at attractive prices. At the same time, issuers must consider how recent changes to the tax treatment of stock buybacks, potential amendments to related disclosure requirements, and other regulatory considerations may impact such capital return strategies. In addition, when evaluating potential capital return strategies, issuers have a wide variety of stock buyback program implementation options to choose from, including open market plans, accelerated share repurchase (ASR) transactions, and structured share repurchase plans. In the discussion that follows, we survey these recent regulatory developments concerning stock buybacks and current trends in structuring considerations for issuers considering implementing a stock buyback program.
Stock Buyback Excise Tax
The Inflation Reduction Act of 2022 added a nondeductible 1% excise tax on many stock buybacks under new Section 4501 of the Internal Revenue Code of 1986, as amended (the Code). Beginning January 1, 2023, a “covered corporation” (generally, any US domestic corporation with securities publicly traded on an exchange) is required to pay a 1% excise tax on the fair market value of any stock repurchased by the “covered corporation” or its “specified affiliate” (i.e., any direct or indirect corporate subsidiary in which the covered corporation owns a greater than 50 percent interest by vote or value or partnership in which the covered corporation owns a greater than 50 percent capital or profits interest). A “repurchase,” for purposes of the excise tax, generally includes any redemption and any other “economically similar” transaction, which can include a tender offer, a cash merger, or a distribution in excess of the corporation’s “earnings and profits,” but generally does not include a distribution in complete liquidation. It is currently expected that all “covered corporations” will be required to report and pay any applicable excise tax once per year on IRS From 720. Certain repurchases are exempt from the excise tax, such as:
- A transaction that qualifies as a “reorganization” within the meaning of Section 368(a) of the Code in which no gain or loss is recognized by the shareholder;
- Stock repurchases where the repurchased stock, or an equivalent value of stock, is contributed to employer-sponsored retirement plans, employee stock ownership plans or similar plans;
- Stock repurchases totaling $1 million or less, in the aggregate, during the taxable year (calculated prior to any adjustment under the netting rule (described below) and before considering any other statutory exemptions);
- Stock repurchases made by securities dealers as part of their regular business activities;
- Stock repurchases by RICs or REITs; and
- Stock repurchases treated as “dividends” for US federal income tax purposes.
The amount subject to tax may be reduced under a netting rule, which reduces the amount of stock treated as repurchased by the fair market value of any stock issued by the “covered corporation” during the taxable year, including the fair market value of any stock issued or provided to employees of the covered corporation or its specified affiliates under a qualified plan (as defined in Section 401(a) of the Code), an employee stock ownership plan, a stock bonus plan, a stock option plan or a similar plan.
Proposed Form SR Reporting
Currently, Item 703 of Regulation S-K requires US issuers to disclose on a quarterly basis on Form 10-Q (and annually on Form 10-K): (i) the total number of shares repurchased by the issuer during the relevant period, reported on a monthly basis and by class; (ii) the average price paid per share; (iii) the total number of shares repurchased; and (iv) the maximum number (or approximate dollar value) of shares that may yet be repurchased under the issuer’s plans or programs.
On December 15, 2021, the SEC proposed increasing the frequency and amount of public disclosure regarding an issuer’s stock repurchases. The SEC’s proposed rules would require issuers, including foreign private issuers and certain registered closed-end funds, to submit a new Form SR to the SEC before the end of the first business day following the day the issuer executes a share repurchase. Form SR would require disclosure that describes: (i) the class of securities purchased; (ii) the total amount purchased; (iii) the average price paid per share; (iv) the total number of shares purchased on the open market; and (v) the aggregate total amount of shares purchased on the open market in reliance on the safe harbor in Rule 10b-18 or pursuant to a plan that is intended to satisfy the affirmative defense conditions of Rule 10b5-1(c). If adopted as proposed, the amendments would also require an issuer to state the objective or rationale for the share repurchases as well as the process or criteria used to determine the repurchase amounts; any policies and procedures relating to purchases and sales of the issuer’s securities by its officers and directors during a repurchase program, including any restriction on such transactions; and whether the issuer is making its repurchases pursuant to a plan that is intended to satisfy the affirmative defense conditions of Rule 10b5-1(c) and/or the conditions of the Rule 10b-18 safe harbor. Notably, in December 2022, the SEC reopened the comment period on these proposed rules. This could have been driven, at least in part, by the extent of the negative reactions to some of the timing and frequency requirements in the proposed rule.
Changes to Rule 10b5-1
On February 27, 2023, the SEC’s amendments to Rule 10b5-1 went into effect. Rule 10b5-1 provides an affirmative defense for trading “on the basis of” material nonpublic information (MNPI) in violation of Section 10(b) of the Securities Exchange Act, as amended (the Exchange Act) and Rule 10b-5 under the Exchange Act. The affirmative defense may be available if, before becoming aware of the information, the person (1) entered into a binding contract to purchase or sell the security; (2) instructed another person to purchase or sell the security for the instructing person's account; or (3) adopted a written plan for trading securities.
The amendments impose new requirements that a trading plan must satisfy in order to qualify for the Rule 10b5-1 affirmative defense. In particular, the changes to Rule 10b5-1 include a requirement that officers and directors must wait between 90 and 120 days before transactions can be made under a plan, a new prohibition on overlapping trading plans and single trade plans, additional public disclosures about the plan, and new required representations. However, the SEC’s adopting release to amended Rule 10b5-1 makes clear that the changes do not apply to an issuer in relation to repurchases of its securities. Issuer stock buyback plans may thus continue to rely on the affirmative defense provided by a Rule 10b5-1 plan without the additional conditions applicable to officers and directors. Issuers may still enter into overlapping Rule 10b5-1 repurchase plans, may still enter into ASRs and structured share repurchases in reliance on Rule 10b5-1, and retain the ability to enter into concurrent ASR and cash open market buyback plans. If the SEC had applied the 90 to 120 day waiting period to issuers, ASRs and structured share repurchase transactions would have become economically impracticable, thereby eliminating important repurchase strategies for issuers.
While issuer repurchase plans will be largely untouched by the changes to Rule 10b5-1, some ambiguity remains. For example, the SEC did not define whether an “issuer” for these purposes includes an issuer’s parent or subsidiaries. This uncertainty could be relevant and will warrant further consideration if a parent or subsidiary is the entity repurchasing the issuer’s securities.
Implementation Options and the Emergence of Structured Share Repurchases
Issuers have traditionally selected from repurchase strategies such as ASRs, selling puts, purchasing zero-strike call spreads, tender offers, and open market repurchase plans. In an open market plan, the issuer’s broker makes purchases on the exchange on the issuer’s behalf under Rule 10b-18, which provides a safe harbor from manipulation liability. Compliance with Rule 10b-18 generally requires that an issuer stock buyback (i) must be executed with a single broker or dealer on any single day; (ii) is not the opening trade of the day nor made in the last 10 minutes of the trading day; (iii) is not executed at a price that exceeds the last independent bid or price; and (iv) is executed such that the total volume of repurchase is less than 25% of the average daily trading volume of the issuer’s stock. For cash open market buybacks, the issuer typically pays the broker a small per share commission and settles the transactions on a T+2 basis. Open market repurchases can be executed on a daily basis (during the issuer’s open trading window) under a Rule 10b-18 engagement letter, whereby the issuer makes a representation each day that it is not in possession of MNPI, or over a period of time (which may be during a blackout period) if documented as a written trading agreement under a Rule 10b5-1 plan. Open market plans can provide the issuer with some flexibility (to the extent permitted if executed as a Rule 10b5-1 plan) but provide less certainty regarding the price and number of shares that may be repurchased.
In an ASR, the issuer commits to repurchase a fixed dollar amount or fixed number of shares from a dealer. If the issuer enters into an ASR based on a fixed dollar amount, the issuer pays the prepayment amount to the dealer at the beginning of the trade and the dealer makes an upfront delivery of shares to the issuer. The upfront delivery is usually 75% to 90% of the shares that may ultimately be repurchased under the ASR. To acquire the shares, the dealer borrows shares from stock lenders. After the dealer has borrowed the shares and sold the shares short to the issuer, the dealer will have a short position in the issuer’s stock. To cover this short position, the dealer will purchase the issuer’s shares on the exchange for a period of time. This period of time, typically called the “averaging period,” will be a period of weeks or months but may be accelerated by the dealer if the dealer closes out its short position before the final averaging date stated in the confirmation. On the earlier of any acceleration date or the scheduled final averaging date, the dealer will calculate the settlement price. The settlement price will be the arithmetic average of the VWAPs on each day during the averaging period minus the agreed discount for the ASR. Generally, the dealer will deliver to the issuer a number of shares equal to the prepayment amount divided by the settlement price, minus the shares delivered up front. The number of shares delivered by the dealer may be subject to a cap or collar, a maximum or minimum number of shares that can be repurchased under the ASR. If the issuer’s stock price increases significantly during the averaging period, the issuer can elect to settle the ASR by paying cash or delivering restricted shares to the dealer. The ASR is documented under a long-form confirmation that incorporates an ISDA 2002 Master Agreement and the ISDA 2002 Equity Derivatives Definitions (the Equity Definitions). Corporate actions by the issuer and market disruptions are addressed by making elections and amendments to the Equity Definitions in the confirmation. The confirmation for the ASR transaction can be fairly complex because the ASR is documented to achieve favorable equity accounting classification under ASC 815-40 (Derivatives and Hedging: Contracts in Entity’s Own Equity) and to comply with the requirements of Rule 10b5-1 and other securities law considerations.
The acceleration right in an ASR can have value to the dealer. As a result, the dealer can offer the issuer a discount to the VWAP of the shares during the averaging period. Depending on the volatility of the issuer’s shares, the length of the averaging period, interest rates, and other factors, the discount to VWAP (relative to a traditional cash open market plan) can be substantial. Most issuers immediately retire the shares received in an ASR, which can be accretive for earning per share (EPS) calculations. For issuers that pay a dividend, retiring the shares up front can reduce the amount of cash spent on dividends paid on shares outstanding. While the discount to VWAP and potential immediate EPS accretion can be attractive to issuers, some issuers find the documentation or execution of ASRs to be complex.
To achieve the favorable economics of an ASR while retaining the flexibility and simplicity of a cash open market repurchase plan, structured open market share repurchases have emerged as an alternative structure to implement stock buybacks. In a structured open market program, the issuer receives a discount to VWAP from the dealer on its repurchases but can retain the ability to terminate or amend the program (unless structured in accordance with Rule 10b5-1). To receive a discount to VWAP, the dealer will make purchases in accordance with a pricing grid developed by the issuer or its adviser. The grid may specify the dollar amounts, share amounts and/or price limits of repurchases. The grid is intended to achieve similar favorable economic outcomes of an ASR by monetizing the volatility of the share prices. However, unlike an ASR, there is no up-front cash payment to the dealer or an up-front receipt of shares from the dealer. Each day during the structured share repurchase program, the dealer makes purchases in accordance with the grid. The transactions settle on a T+2 basis like a traditional cash open market program. The structured share repurchases can be documented under a Rule 10b-18 engagement letter or as a Rule 10b5-1 plan. Given the attractive pricing and relative simplicity, structured share repurchases may become increasingly popular if volatility or interest rates remain elevated.
Market conditions in recent years have seen more and more US companies pursue share buyback programs, and current indications suggest this trend continuing into 2023. Beyond market conditions and evaluation of the optimal stock buyback structure from a price and performance perspective, there are a range of other considerations, as surveyed above, that issuers should take into account when determining whether to pursue a stock buyback program. These include potential tax consequences to the issuer and recent changes to relevant public disclosure and safe harbor requirements, but also the need to ensure necessary corporate governance and authorization steps are taken, from board approval to public announcement, before entering into stock buybacks. Given the range of potential stock buyback implementation options available to issuers and the commercial and regulatory considerations that issuers need to be apprised of in evaluating such options, issuers should consult closely with their legal and other professional advisers in order to achieve the most favorable outcomes.