Add a new wrinkle to the longstanding debate about the wisdom of share-repurchase programs: claims of a conflict of interest.
Companies cite many good reasons for buying back shares: the practice boosts earnings per share, it sends a signal that the company considers its shares undervalued, and it finds a use for some of that vast cash horde many firms have. Companies could, of course, pay a dividend, but many prefer the flexibility of buybacks because they are occasional events (the issuance of a dividend usually creates an expectation of regular payouts).
But what happens when a company buys back its shares at the same time that executives are selling theirs? There are no laws to prohibit officers and directors from selling company stock while the company is buying. But at a time when investors and regulators are hypersensitive to even the appearance of conflicts of interest, some critics are asking whether officers and directors who promote and authorize massive stock-buyback programs should also be taking the other side of those trades.
"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," argues plaintiff's attorney William Lerach of Lerach Coughlin Stoia Geller Rudman & Robbins LLP in San Diego. "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."
Three years ago, Lerach helped negotiate a settlement of shareholder litigation with Sprint Corp. (now Sprint Nextel Corp.) in which Sprint agreed that it would no longer allow insiders to sell Sprint shares while the company was buying them. A Sprint spokeswoman says the prohibition applies only under "certain limited circumstances," but declined to elaborate. Lerach says it is a reform other corporations ought to embrace voluntarily.
Few have, at least in part because both buybacks and stock options as a form of compensation are relatively recent phenomena. In 1980, for example, the value of stock buybacks exercised by S&P 500 companies equaled just 10 percent of the value of the dividends issued, according to Scott Weisbenner, a finance professor at the University of Illinois who studied the issue while serving as an economist at the Federal Reserve Board from 1999 to 2000. By the late 1990s, however, companies were spending more on repurchases than on dividends. And the boom continues: in the second quarter of this year, buybacks outpaced the same period a year ago by 43 percent, while dividends accounted for just 32 percent of cash paid out to shareholders, down from 51 percent as recently as the second quarter of 2001. Weisbenner also found that between 1994 and 1998, the use of stock-options programs by S&P 500 companies grew by more than 40 percent.
"The world in which [insider trading] laws were made existed before the world in which there were massive buyback programs," says Robert Monks, a shareholder activist, attorney, and investment-fund partner. "I don't think anyone foresaw how these two trends would play out together."
Options Play
Critics contend that potential conflicts of interest take several forms. For starters, options holders aren't eligible to receive dividends, which may make them turn a blind eye to a practice that would benefit other shareholders. And dividends dilute the value of options because the share
price is typically marked down to reflect the value of the dividend issued. In addition, a prime motivator for buybacks — to boost earnings per share — is seen by critics as potentially self-serving because many executives are compensated at least in part based on EPS targets, so using company money to inflate that figure can result in personal gain. Less clear is whether buybacks actually bump up the price of shares, allowing executives to garner more than they would have otherwise (see "More Knocks Against Buybacks" at the end of this article).
But as those recent figures on buyback activity indicate, rumblings from certain quarters seem to be having no effect on the popularity of the practice. "I think there's a responsibility, if you accumulate too much cash on the balance sheet, to make a decision of some kind to return money to shareholders, unless you have it earmarked for something else," says USANA executive vice president and CFO Gilbert Fuller. "Over the past five years, we've bought back something like 6.5 million shares, and spent $130 million doing so. And we've chosen to do that rather than issue a dividend, primarily because it gives us more flexibility."
The company spent nearly $50 million between 2005 and the first quarter of 2006 alone, a period during which company insiders sold USANA shares worth approximately $64 million. Fuller cites several reasons for that activity, noting that the company's stock went from less than $1 a share in 2002 to more than $40 per share this year. "First of all, it takes an iron stomach not to sell into that," says Fuller. "Second, it's a way for executives to balance out their cash needs. And third, there's the issue of diversity. If you wake up and see that your stock has gone from under $1 to $44, common sense says you should diversify some of your holdings."
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