Real Effects of Share Repurchases Legalization on Corporate Behaviors

Background

A central topic for corporations is how they manage their cash. The decision to distribute cash to shareholders is among the most important ones for corporate managers with substantial free cash flows. Although share repurchases serve as one of two major distribution methods nowadays, the practice of repurchasing shares was not largely adopted by firms until the 1980s, when major countries started to legalize it. Prior to the 1980s, even though firms could conduct private tender offers, this strategy usually involved high services fees paid to third parties or high premiums paid to tendering stockholders. These obstacles lead to the unpopularity of share repurchases before legalization. However, since major economies around the world gradually legalized open market share repurchases in their stock markets during the 1980s and 2000s, repurchasing shares has become increasingly popular for publicly listed firms. For instance, according to a report by Yardeni Research 2020, in the United States, approximately $700 billion shares were repurchased by S&P 500 companies in 2019, marking the tenth consecutive year in which share repurchases exceeded dividend payments.

Share Repurchase Legalization Around the World

We manually collect global information about repurchase legalization from various legal filings, such as industry reports, academic articles, and the websites of regulatory authorities, stock exchanges, and governments. For example, based on the Treasury Shares Guide prepared by the Corporate and M&A Committee of the International Bar Association (IBA) in 2014, Russia legalized share repurchases in 1995 following the implementation of Federal Law No. 208-FZ on Joint-Stock Companies. Germany started to permit share repurchases in 1998 when the country passed the Corporation Control and Transparency Act (KonTraG) and amended some provisions in the Stock Corporation Act (Aktiengesetz) to improve corporate governance in German companies. The China Securities Regulatory Commission implemented the Administration of Repurchases Procedures of Public Shares by Listed Companies in 2005. Kuwait’s government website states that the country issued the Capital Markets Authority Law in 2010 to regulate securities activities, including share repurchases.

In some scenarios, the deregulation was not achieved via a single law adoption; rather, the process was gradually accomplished by passing multiple laws. For instance, Japan removed the restrictions gradually after revising two laws: The Commercial Law in 1994 and the Tax Reform Act in 1995. We treat 1995 as the legalization year because the Tax Reform Act removed a significant tax disadvantage for share repurchases, encouraging public firms to undertake stock buyback programs.

Moreover, some restrictions could still exist even after open market share repurchases legalization. Share repurchase programs usually need approval by shareholders, and there may be price and volume restrictions in some markets. For example, in Canada, the repurchasing price cannot be higher than the most recent price, and the repurchasing volume cannot exceed 5% of the total shares outstanding. In Japan, the maximum repurchasing price is the closing price of the previous day, and the maximum repurchasing volume per day is 25% of the daily volume in the previous month. The Singapore Exchange requires that the repurchasing price upper limit is 5% above the average price of the previous five trading days, and the maximum repurchasing volume is 10% of total shares outstanding.

Our final sample includes 17 economies: Canada (legalized in 1985), mainland China (2005), Germany (1998), Greece (2003), Israel (1999), Japan (1995), Kuwait (2010), the Netherlands (1992), New Zealand (1994), Russia (1995), Singapore (1998), South Africa (2000), South Korea (1994), Spain (1989), Switzerland (1992), Taiwan (2000), and Turkey (2009).

Repurchase Legalization and Corporate Behaviors

The legalization setting on an international scale creates a relatively exogenous shock on individual firms because it is unlikely that the law change is primarily driven by some individual firms. Moreover, in contrast to many related publications that use U.S. data, our study offers a global prospect about the potential real effects of repurchase legalization on corporate behaviors. We find that repurchase legalization does have a significant influence on corporate behaviors, including payout policies, investment and financing strategies, stock returns, and long-term firm valuation.

To be specific, for firms that buy back shares immediately after repurchase legalization, total payouts increase by 47% relative to the average, but dividends are sticky and firms do not cut dividends as a substitution. To finance share repurchases, these firms mainly rely on internal cash rather than external debt issuance, which makes cash holdings decline by about 2%. Consistent with the reduction in funding resources, long-run investments in capital expenditure and R&D activities also drop significantly. Cuts in these investments further hurt corporate performance in a long term, as implied by lower valuation, profitability, sales growth, and patents in several years after repurchase legalization. Different from the negative long-run influence, short-term stock reactions to repurchase legalization are positive, and firm insiders sell some of their holdings when the stock price has been moved up by repurchases. Therefore, one reason firms buy back shares may be to boost stock prices and to benefit inside shareholders when they sell their holdings.

Furthermore, these post-legalization effects are different for different economies or different firms. We find that the effects of repurchase legalization on firm operations attenuate in economies with trading restrictions on share repurchases, in economies with lower net tax rates on dividends, and for more financially constrained firms.

In addition, using this legalization experiment, we also address a fundamental question about repurchase motivations. We find that firms are more likely to repurchase right after legalization in economies with a higher dividend tax penalty, which is the extra tax burden of dividend income compared to capital gains. Moreover, firms with more volatile net income and a temporary cash flow shock before legalization are more likely to have post-legalization repurchases, which contributes to the argument that firms can use share repurchases to avoid long-term commitment and pay out temporary cash flows.

Taken together, our study shows that, after the legalization of share repurchases, firms use cash to buy back shares and boost their stock prices, but this strategy undermines long-run performance because firms must sacrifice long-run investments and innovations. Tax benefits and paying out temporary earnings are two primary reasons these firms choose to repurchase right after the law change.

The complete paper is available for download here.