In testimony before Congress, Harvard Law School professor Jesse Fried outlines the potential for abuse in stock buybacks:
Executives can use buybacks to transfer value from public investors to themselves, reducing investor returns and, perhaps, distorting corporate decision-making in a way that reduces the size of the overall economic pie. This abuse is facilitated by the lax disclosure rules applicable to buybacks.
Indirect Insider Trading. Executives will have an incentive to conduct a buyback when they believe that the stock price is less than the stock’s actual value (a “bargain repurchase”). A bargain repurchase transfers value from selling shareholders to non-selling shareholders pro rata. Thus, to the extent insiders own shares in the firm and decline to sell their shares at a cheap price (which they can be expected to do), they will benefit from a bargain repurchase.
Insiders of U.S. firms announcing repurchases tend to own a substantial fraction of the firms’ shares before the repurchase—an average of 15-20%—which is roughly the same as the average insider ownership across all firms. Thus, when insiders know that stock prices are low, they have a strong incentive to conduct a bargain repurchase to transfer value from selling shareholders to themselves and other non-selling shareholders. There is substantial evidence of bargain repurchases, and I have estimated that insiders divert about $5 billion annually through them, at the expense of public investors.
This indirect insider trading is facilitated by the current disclosure rules, which make it difficult to enforce Rule 10b-5 against the firm and which fail to provide public investors with real-time disclosure about the firm’s repurchase activity. For example, if investors knew that the firm was aggressively buying shares, they might infer that the stock is underpriced and reassess their valuations of the firm, causing the price to rise and making it harder for insiders to conduct a bargain repurchase.
EPS and Stock-Price Manipulation. There is evidence consistent with executives engaging in buybacks to boost EPS when they are in danger of falling short of forecasted EPS, although it is unclear whether public investors are harmed. Executives might also conduct repurchases to exert upward price pressure on the stock while selling their shares, which would systematically transfer value from public investors to themselves. Depending on how executives’ EPS-based bonuses are structured, executives might have an incentive to buy back shares simply to trigger a bonus, which again enriches them at public investors’ expense. The lack of detailed, timely disclosure of repurchases emboldens insiders to engage in these strategies by making the abuse difficult to detect.
False Signaling with Misleading Repurchase Announcements. Managers wishing to sell their own shares at a higher price may have an incentive to announce a share repurchase they do not intend to conduct simply to boost the stock price. A repurchase program announcement is generally greeted favorably by the market, as it can signal the stock is undervalued or that excess cash will finally be distributed (rather than being wasted or left to languish inside the firm). By announcing a repurchase program even when they have no intention of repurchasing stock, managers about to sell their own shares essentially attempt to “mimic” managers of firms that use repurchases to buy stock at a low price (or simply to distribute cash). This mimicking appears to be successful: there is no difference in market reaction between announcements followed by repurchase activity and announcements not followed by actual buybacks. To the extent that managers use misleading repurchase announcements to sell their shares for more than their actual value, they transfer value from the parties buying their shares.
His proposed solution:
“[A] corporation should be required to disclose each trade in its own shares within two business days of the transaction. This two-day rule would improve transparency and provide public investors with a timely, accurate, and comprehensive picture of insiders’ trading, both direct and indirect via the firm…I have elsewhere proposed that both insiders and firms be required to disclose their planned trades in advance. Such a pre-trading disclosure rule, I have shown, would substantially reduce the costs associated with direct and indirect insider trading. Thus, I do not claim that the two-day rule proposed here is ideal. Rather, I see the adoption of such a rule as an easy (but important) step in the right direction—-a measure that would harmonize insider-trading rules, improve transparency in the capital markets, and substantially reduce indirect insider trading and its costs. But should the detailed disclosure provided by the two-day rule indicate that abuses were continuing, more aggressive steps—such as requiring pre-trading disclosure—could be considered.”