Stock repurchases with legal restrictions. Evidence from Spain

Abstract

This paper analyses the consequences of legal restrictions on the volume of shares firms can repurchase. Results suggest that the imposition of a limit on the volume of common stock favours the use of open market repurchases (OMRs) compared to other methods of repurchase such as tender offer repurchases (TORs) and Dutch auctions (DAs). The positive share abnormal returns around both announcements of open market buybacks and sellbacks in the full sample suggest that they are basically used to change the ownership structure of the firm in a consistent way with the convergence of interest hypothesis. The positive abnormal stock returns around open market repurchases, which are significantly different to the negative ones around sellbacks, when there are no changes in ownership structure also indicates the existence of a signalling and free cash flow effects.

Keywords:

• buybacks
• sellbacks
• corporate control
• signalling
• free cash flow
• event study

Acknowledgements

We wish to thank the referees, the editor and the participants of the Financial Management Association Conference at Edinburgh (2000) and the European Financial Management Association at Athens (2000) for helpful comments and suggestions. We also acknowledge the financial support provided by the Spanish Education Ministry, (CICYT), Projects SEC97-1307 and BEC2000-0982.

Notes

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In fact, Rau and Vermaelen (2000) and Rees (1996) find that UK firms announcing share repurchases have smaller abnormal returns than those obtained by US firms. Rau and Vermaelen (2000) explain this result using two factors. First, because the UK regulatory environment discourages share repurchases designed to take advantage of an undervalued stock price. Second, many buyback programmes are set up to allow pension funds to earn tax credits.

These reasons also justify the small size of the sample of open market buybacks and sellbacks in the Spanish case.

This figure represents the minimum number of authorizations, as some firms do not indicate the agenda in their notification for meetings. This prevents us from knowing whether authorization was granted or not.

Although studies in the USA have proposed tax advantages of repurchase programmes compared to cash dividends, such motivation cannot be applied in the Spanish case. In our analysis period (1990–1997), the effective taxation of dividends and capital gains depends on the type of shareholder. For individual investors there is no clearly different taxation because whereas dividends were taxed at higher rates, special tax deductions were also applied. Pension funds and mutual funds were indifferent between dividends and capital gains for tax reasons because they were tax-exempt investors. However, when the shareholder is another firm, this type of shareholder prefers dividends over capital gains because dividends have tax additional deductions for them. So, contrary to the US case the Spanish Tax System does not provide reasons for using repurchase programmes instead of cash dividends as the only type of investors with a clearly different treatment of dividends and capital gains has a preference for dividends. For this reason, the tax explanation is not included as a potential motivation of the repurchase activity in the Spanish market.

See, among others, Cowan and Sergeant (1996) and Maynes and Rumsey (1993) for a review of the consequences of the presence of nonsynchronous trading on the standard tests of event study.

The share abnormal returns could also reflect microstructure effects different to the three motivations explaining the repurchase activity. So Barclay and Smith (1988) suggest that if additional informed traders (managers) enter the market purchasing or selling shares of their own firm, the bid–ask spread will be wider and will reduce the liquidity of firm securities. However, this liquidity effect will elicit negative share abnormal returns both for open market buybacks and sellbacks that are not consistent with the positive ones observed in the paper. The previous empirical evidence is not clear about this microstructure effect even in the USA. Although Barclay and Smith (1988) find an increase in the annual bid–ask spread of the repurchasing US firms, Singh et al., (1994) and Leach et al., (1998) do not support this result using daily bid–ask spread data.