From the February 2011 issue of Treasury & Risk magazine

Saving Bucks on Buybacks

The SEC's proposal to bring stock repurchases rules in line with evolving market conditions could give companies access to the latest tools to execute large trades anonymously.

The only time delivery company UPS contemplated breaching the Securities and Exchange Commission's safe-harbor rules on repurchasing company stock was the morning of the Sept. 11, 2001, terrorist attack on the World Trade Center.

Futures were down before the stock market opened that day, and Gary Barth, assistant treasurer and vice president at the Atlanta-based company, says he explained to his CFO that to support its stock price, UPS would face a market in which the only bids would be its own. That would almost certainly have resulted in UPS' falling outside the SEC's safe-harbor rules, which require that companies pay no more to repurchase stock than the highest independent bid or last independent sale price.

Scott Davis, UPS's CFO at the time and currently its CEO, gave the go-ahead. The issue was ultimately moot because the stock market never opened that day. However, UPS' predicament illustrates corporate America's reluctance to breach the safe-harbor restrictions, which include purchasing stock using no more than one broker-dealer per day; honoring limits near the market open and close; and purchasing no more than 25% of a stock's average daily trading volume.

Although there are no penalties for breaching the safe harbor, companies are wary about doing so. But its restrictions can impede efficient stock repurchases.

Such concerns may soon subside. The SEC put forward a proposal last year to modernize the safe-harbor, Rule 10b-18, and align it more closely with current market dynamics.

The proposal aims to clarify restrictions around repurchasing stock at the open and close, which have become ambiguous in the current highly fragmented stock market. It would also limit safe-harbor disqualifications inadvertently occurring in today's hyper-fast market and provide exceptions to pricing limitations, so companies can use newer trading strategies that may mean marginally higher costs but more effectively hide their large trades from opportunistic market participants.

Vlad Khandros, a corporate strategy executive at New York-based Liquidnet, an alternative equity trading platform, says his company has met with SEC commissioners and staff "a number of times" recently and anticipates approval of a final rule soon.

"Soon" may be a relative term, given everything the SEC has on its plate. On the other hand, companies' financial situations may push the agency's hand. Khandros says feedback Liquidnet has received from corporate customers, in light of their record cash and relatively low stock prices, suggests 2011 could be a big year for stock repurchases.

Liquidnet typically services institutional investors but has increasingly sought to act as a bridge between companies and those investors through services such as InfraRed, which purports to give companies insight into demand for their stock. In addition, Liquidnet's matching engine aims to execute large trades anonymously, which could benefit companies repurchasing stock by keeping information about their intentions from leaking into the market and potentially increasing the cost of the trade.

In fact, the primary benefit for corporates of modernizing Rule 10b-18 may be allowing them greater access to tools that execute large trades as anonymously as possible. Those tools could be so-called "dark pools" like Liquidnet's or algorithms that break large trades into tiny pieces to minimize their price impact.

Khandros says Liquidnet is in discussions with several companies interested in accessing its matching engine to execute their large buy orders directly with the types of institutional investors--pension or mutual funds, endowments, etc.--they want as long-term shareholders.

By matching "natural" block orders directly and anonymously with the institutions using dark pools, instead of on quote-displaying exchanges via brokerage firms, companies can significantly reduce costs arising when information about their orders leaks out and opportunistic traders buy the company's stock ahead of its larger order.

"By taking out the middle man [broker and exchanges], the corporates and investors win," Khandros says.

Nevertheless, companies' cash stockpiles may not signal an immediate intention to repurchase stock . Thomas Deas, treasurer at FMC Corp. and president of the National Association of Corporate Treasurers (NACT), notes that one of the "big reasons" companies are hoarding cash is their more conservative approach to their financial health in volatile times. That could dampen enthusiasm for stock repurchases until volatility fades, he says.

Deas says the major banks his company works with have said that many companies canceled buyback programs in 2008 and have yet to resume them. While NACT members discussed the SEC's 10b-18 proposal when it was issued, "it's certainly not something constituents are pounding the table about," Deas adds.

Still, giving companies more flexibility in their efforts to buy back stock may be a long-term boon. The safe harbor was established to assure companies--the ultimate insiders that if they followed its parameters, the SEC would not accuse them of manipulating their stock prices. But the capital markets have changed drastically since Rule 10b-18 was issued in the early 1980s, especially over the last decade.

When UPS first issued stock in 1999, says Barth, more than 90% of its shares traded on the New York Stock Exchange. Today, that percentage is just over 22%. U.S. exchanges' switch in 2001 to quoting stock prices in decimals instead of eighths of a dollar has been another factor.

"Finding liquidity has become much more difficult," Barth says, adding that decimalization also made it easier for other participants to recognize when large blocks of securities enter the market.

"Players taking the other side of the trade can say, 'Let's front-run the corporate,'" he says. "They can lift their offers a penny higher, drive up the stock price on relatively little volume, and then give [the shares] back to me at a higher price."

Using brokers' algorithms can provide some anonymity. But they, too, abide by the safe-harbor restrictions, which stretch out the execution time for very large orders and increase the risk that trading firms will trade against companies' buyback orders and raise costs.

Barth says restrictions on repurchases near market opens and closes should be loosened so companies can do more to support their stock prices when there are imbalances in bids and offers.

To ward off opportunistic traders, Barth says, his company supports an exception to Rule 10b-18's price restrictions proposed by the SEC that would permit the use of value-weighted average price (VWAP) algorithms, which break large orders into small pieces that are executed over a defined time period, such as a day. That lessens the chance of opportunistic market participants recognizing the company's intentions. However, some of those executions may be at a price above the highest independent bid or the last independent sale price, a breach of Rule 10b-18.Cigna and ExxonMobil also submitted comment letters supporting a VWAP exception.

Liquidnet and Investment Technology Group, another dark pool provider, submitted comment letters supporting VWAP, as well as another proposed exception for orders executed at the midpoint between the current bid and offer. Midpoint pricing, too, would be above the highest independent bid or the last independent sale price. That's no surprise, given such providers' matching engines execute orders at the midpoint, and corporates represent another source of execution volume. However, dark pools aim to execute large orders anonymously, often much faster than algorithms.

Barth says UPS typically doesn't buy back very large blocks of stock. "But I want to feel like Felix the Cat sometimes, with my bag of tricks," he says. "If I need to do half a million shares, I want to be able to do that."


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