The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

In the latest manifestations of what Forbes magazine recently (here) called "the biggest buyback binge in the history of the market," both Home Depot and Expedia announced that they would undertake massive amounts of debt to buyback significant portions of their outstanding shares.

The Home Depot plan (which it announced here) is particularly mind-boggling. According to the Wall Street Journal's June 20, 2007 article entitled "Home Depot Boosts Buyback, Sets Unit Sale" (here, subscription required), Home Depot's plan authorizes additional share buybacks of $22.5 billion, bringing the total authorized level of share repurchases to a staggering $40 billion. This is a company with a $74.9 billion market cap. Although an asset sale will fund $10.3 billion of the newly authorized share buyback, the remaining $12.2 billion will be financed with debt.

Expedia's plan (which it announced here) is that it will repurchase as many as 117 million of its Class A shares, which represents as much as 42% of its shares, and will spend up to $3.5 billion, as much as $2.5 billion of which will be financed with debt. Expedia's current market cap is $8.8 billion.

These companies share prices responded positively to these announcements, and there are indeed arguable benefits to these types of transactions. As the Wall Street Journal note (here, subscription required) in discussing the Expedia leveraged buyback, "reducing the outstanding stock can help a company boost per-share earnings, as the profit is divided by fewer shares. Also, interest payments on [the] debt are tax-deductible."

But not all of the effects of a leveraged buyback are beneficent or benign. As the recent Forbes article (here) commented, buybacks "give a temporary, one-time artificial boost to earnings, they cause creaky cash-poor companies to load up on debt, leaving them vulnerable should the economy unexpectedly deteriorate and they pulverize credit ratings, causing borrowing costs to soar." The credit rating concern may already have affected Home Depot; according to the Journal, Standard & Poor's rating service and Moody's Investor Service "both placed Home Depot's credit ratings under review for possible downgrades."

Detailed research suggests that the buybacks, at best, may provide "a short-term steroid shot." The Forbes article quotes research from Birinyi Associates, which looked at the stock performance of 375 S & P companies that bought back shares in the six years through December 2006. Over that period, the companies' median return post-buyback was 56%, far less than the 72% at companies that did not repurchase, and the average return post-buyback was 102%, less that then 131% at companies that did not repurchase.

Nevertheless, S & P 500 companies repurchased $432 billion of their own stock in 2006, more than triple the 2003 amount. Why are companies doing this? One guess is executive pay. The Forbes article notes that "buybacks can goose executive pay, because executive compensation is often linked to earnings per share." Indeed, the Journal article discussing the Expedia share buyback plan, in trying to understand the plan, noted that "Expedia's proxy statement gives one explanation: Executive Compensation is pegged to, among other goals, enhancing per-share earnings. And that looks to be one result of this particular buyback." It is also probably worth noting that using share repurchases to boost executive bonus comp based on an EPS trigger is one of the practices for which Home Depot's departed CEO Robert Nardelli was criticized, as I previously noted here.

One particularly troublesome form of share buybacks involves an aggressive, debt-financed buyback program that coincides with active insider sales. A recent study by Audit Integrity (cited in the Forbes article) identified 13 companies with market caps over $100 million that had both high levels of stock buybacks and insider selling. But the insiders sales don't necessarily have to be contemporaneous to be troublesome; as the Forbes article notes, "insiders may be way too tempted to do buybacks so they can sell their holdings more lucratively once the buyback pushes the stock price higher."

As I discussed in my prior post (here) about Share Buybacks and D & O Risk, none of this is lost on the plaintiffs' lawyers. Indeed, the Forbes article cites the settlement of the Sprint class action lawsuit settlement "in which Sprint agreed that it would no longer allow insiders to sell Sprint shares while the company was buying them." Sprint may have agreed to this under duress, but this requirement in fact seems like a prudent policy calculated to avoid activity that otherwise presents some troubling visuals. It should not be overlooked that this activity has already attracted the plaintiffs' lawyers attention.

The share repurchase phenomenon may eventually abate as long term interests rates rise and the era of cheap credit comes to an end. We are definitely not there yet, as the Home Depot and Expedia buyback programs announced this week demonstrate. But when the music stops, there are could be some companies, saddled with buyback-motivated debt they are unable to service, refinance or restructure, that could pay a very steep price for their "buyback binge."

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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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