Corporate share repurchases hit record levels in 2021. But as discussed in the following guest post by Sarah Abrams and Bret Hilgart, share repurchases can sometimes result in litigation and share repurchases could have important implications for directors and officers’ liability. Sarah is Head of Professional Liability at Bowhead Specialty Underwriters and Bret is Head of Commercial D&O at Bowhead Specialty Underwriters. I would like to thank Sarah and Bret for allowing me to publish their article as a guest post on this site. I welcome guest posts from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is Sarah and Bret’s article.
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The recent uptick in Shareholder Litigation surrounding Share Repurchase Programs results in various considerations for Board of Directors and Company Management. Approval and oversight by the board in determining share repurchases may lead to potential conflicts of interest. In addition, existing reporting requirements, the SEC focus on insider trading and recent filing recommendations warrant examination.
Share Repurchase programs refer to a public company buying back company shares that were previously sold to the public. A company may choose to repurchase shares to send a market signal that its stock price is currently undervalued, to inflate financial metrics denominated by the number of shares outstanding, to attempt to halt a declining stock price, or simply because it wants to increase its own equity stake in the company.[i] Company management often describe the options for return of excess capital to shareholders as acquisition or capital expenditures to grow the business, issuance of a dividend, or share repurchase.
Notably, a repurchase program is often framed as a return of money to shareholders. The idea being that share buybacks are creating buying pressure while providing liquidity (and that buying pressure is elevating the share price) and/or reducing the number of shares so that price will rise due to the impact on valuation multiples. In the wake of COVID-19, many publicly traded companies repurchased or announced plans to repurchase shares. Management and boards of directors overseeing companies with significant cash stockpiles contemplated the current stock market valuations and determined share repurchase to be the most productive use of their cash.
Share repurchases are often framed as beneficial because they come with a greater degree of flexibility instead of the perceived commitment of a regular dividend. The success of the plan is somewhat dependent on the efficiency in the market, or at least in the trading of the issuer’s shares. If the value is on a per share basis and the share count goes down, the price goes up. The company is thus returning capital to all shareholders by providing liquidity to those interested in selling as well as lifting the value per share for those holding.
Recent litigation attacking company share repurchase programs and the SEC signal of new buyback disclosure rules will impact Board of Director liability.[ii]
Complaint allegations of breach of fiduciary duty stemming from impairment of shareholder rights as the result of repurchase programs are interesting to consider. For negative shareholder impact to occur, a conflicted major shareholder must gain controlling ownership percentage by not selling their own shares in the company. Because the repurchased shares become retired, the ability for minority share ownership decreases. The result may be the major shareholder obtaining controlling interest and therefore power over company board decisions. It is not unheard of that various board members may have a relationship; ownership or other interest as an advisor or consultant to the major shareholder which, at minimum, creates the appearance of a conflict of interest.[iii]
Notably, under Delaware law and the law of other states, directors may have personal [indemnifiable] liability for an unlawful share repurchase.[iv] The cost to defend such allegations may be allocated or multiplied depending on the interested party involvement, particularly individual board members that might implicate Outside Director Liability cover.
With Share Repurchase plans authorized and approved by the Board of Directors, documented discussion of the repurchase impact on the cash position of the company, the capital needs of the company and whether there is a better alternative use of the company’s cash surplus by the board is prudent. Since many share repurchases are executed over time[v], company boards should be able to demonstrate intended impact with resulting price and valuation multiples as well as discussion over whether repurchase should continue; i.e. whether the repurchase program is having the desired effect. This will provide a strong defensive framework against purported breach of fiduciary duties.
Another pitfall to be mindful of in light of the SEC’s recent focus on insider trading and related disclosures [vi] is that the company is the “ultimate” insider and therefore, concerns about purchasing shares while in possession of material non-public information are magnified. The SEC has gone a step further to propose new Form SR for reporting issuer share repurchases, which requires disclosure identifying the class of securities purchased, the total amount purchased, the average price and aggregate total purchased on the open market in reliance of 10b-18.[vii]
When considering heightened insider trading scrutiny, a board should review their insider trading policy and trading approvals along the same time horizon. This is not only to determine if the entity could be considered trading on inside information, but how much insiders are trading counter to the buyback. Approving a repurchase and then simultaneously having individual directors or officers selling shares to any heightened degree can have a negative impact on perception.
Finally, Board of Directors and Company Management should be mindful of the indirect consequences resulting from Share Repurchase programs. The 3rd quarter of 2021 is anticipated to be another record for S&P 500 company share buybacks as COVID concerns ebbed[viii]. A closer examination into company capital and share ownership, including any hybrid securities such as convertible debt and or convertible preferred securities that may be affected by share repurchases would be advised. If the combination of reduction of shares outstanding and security conversion results in additional board seats for a major shareholder or even a controlling interest threshold being crossed, the board should proceed with caution.
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[i] Share Repurchase – Overview, Impact, and Signaling Effect (corporatefinanceinstitute.com)
[ii] SEC.gov | SEC Proposes New Share Repurchase Disclosure Rules
[iii] Given executive compensation more often including increased company equity, there may be some consideration as to whether a conflict of interest may result from repurchase programs. This interplay board of directors’ governance exposure should be examined as the scrutiny over buyback programs increases. For additional discussion on D&O Governance Exposure see Guest Post: As Equity Markets Surge, Carriers Need to Examine D&O Governance Exposure | The D&O Diary (dandodiary.com)
[iv] Questions Surrounding Share Repurchases (harvard.edu)
[v] The board will usually approve a repurchase amount and the company will spend up to that amount over the next several quarters. Ideally, quarterly disclosure is thorough enough to determine where they are in that process on at least a quarterly basis.
[vi] SEC.gov | SEC Proposes Amendments Regarding Rule 10b5-1 Insider Trading Plans and Related Disclosures
[vii] SEC.gov | SEC Proposes New Share Repurchase Disclosure Rules. 10b-18 provides a non-exclusive safe harbor against allegations of market manipulation under Sections 9(a)(2) and 10(b) of the Exchange Act and Rule 10b-5 under the Exchange Act solely by reason of the manner, timing, price and volume of the repurchases when the company’s repurchases are made in accordance with the conditions set forth in the rule. Rule 10b-18, however, does not protect against other types of violations of the Exchange Act and Rule 10b-5, such as violations arising from purchases made by an issuer on the basis of material non-public information. https://corpgov.law.harvard.edu/2013/03/14/questions-surrounding-share-repurchases/
[viii] U.S. stock buybacks head for record in third quarter | Reuters