Rule 10b-18 provides hindrence to stock repurchases and increases transaction costs
Many public companies seeking to increase shareholder value through stock repurchases are finding themselves hindered by an outdated federal regulation that is making the process more costly for issuers.
The rule in question is 10b-18, which the SEC adopted in 1982. Rule 10b-18 sets time, price, volume and other restrictions on issuer repurchases. It was well intentioned at the time of its inception as a safe harbor protection against liability for market manipulation, but has not kept pace with the evolution of the equity markets.
In particular, the price condition of Rule 10b-18 can increase an issuer’s transaction costs. To comply with the price condition, all issuer repurchases must be executed at or below the last trade price in the market (commonly referred to as the ‘last sale’ price) or at or below the current best displayed bid price in the market. The intent of the price condition is to prevent issuers from deliberately driving up the price of their stock by continuing to execute against the best offer price in the market. As an example, if the highest posted bid price in a stock is $20.00, the lowest posted offer price in the stock is $20.04 and the most recent trade in the stock was executed at $20.01, an issuer can only repurchase stock at $20.01 or less.
The irony is that the Rule 10b-18 price condition limits the alternatives available to the issuer by restricting the issuer’s access to block crossing systems that can help reduce their trading costs. This is costly to the issuer and contrary to the express intent of Rule 10b-18.
Information leakage
Repurchases today are typically effected through traditional broker-dealers. The broker-dealer takes responsibility for compliance with the price and other conditions of Rule 10b-18. The problem with this is that exposure of the issuer’s order information to a broker-dealer can result in leakage of information about the issuer’s order.
Information leakage leads to higher transaction costs for the issuer as high-frequency and other short-term traders in the market with sophisticated computer trading systems seek to buy stock ahead of the issuer, knowing they can then sell back to the issuer at a higher price. In the example above, if short-term traders can detect an issuer repurchase order, it would not be unusual for them to execute against displayed offers in order to drive the stock price to $20.25 or higher. In many cases, the stock price reverts back to its previous range after the issuer’s repurchase has been completed.
In January 2010, the SEC published a rule proposal to modernize Rule 10b-18. In the proposal, the SEC solicited comments on a series of issues, including whether to modify the rule’s price condition to permit repurchases at the mid-point.
Liquidnet submitted a comment letter to the SEC identifying the advantages of mid-point executions for issuers. We noted that mid-point executions are consistent with the intent of Rule 10b-18 because they are non-directional and the execution prices are derived from independently established, publicly displayed bid and offer quotations. We also noted that mid-point executions in block crossing systems can help issuers maintain the anonymity of their block repurchases, resulting in reduced repurchase costs. This not only saves the corporate issuer money, but also furthers the goals of Rule 10b-18 by reducing price movement against the issuer.
Rule 10b-18 as a safe harbor provision
Rule 10b-18 was drafted to provide issuers with a safe harbor from liability for market manipulation under the securities laws. To qualify for the safe harbor protection, an issuer must meet all the conditions of Rule 10b-18, including the price condition. The safe harbor is not available for repurchases made in technical compliance with the rule that are part of a scheme to evade the securities laws.
Because Rule 10b-18 is a safe harbor rule, issuers can comply with the securities laws without meeting all the conditions of the rule. In fact, it is hard to see how executing repurchases at the mid-point through a block crossing system could be considered manipulative when the intent is exactly the opposite – to minimize adverse price impact. Nevertheless, many issuers consider it prudent to comply with all of the conditions of Rule 10b-18. Interestingly, this presents a potential conflict with the obligation of the issuer’s management to its stockholders to minimize transaction costs. Ultimately, the best solution would be for the SEC to provide guidance that repurchases at the mid-point for the purpose of minimizing adverse price impact would not be considered manipulative activity under the securities laws, absent specific facts evidencing a manipulative intent.
The issuer community (and shareholders) would be well advised to follow and comment on the SEC’s price condition proposals and other aspects of the proposal surrounding buybacks. A dollar saved on transaction costs is a dollar earned.
