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Corporate governance and the market reaction to stock repurchase announcement

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Abstract

This paper investigates the effect of corporate governance on market reaction around of a stock repurchase announcement. We argue that corporate governance affects the ability of a stock repurchase to alleviate agency costs related to free cash flows, and the credibility of the undervaluation signal sent by the announcement of buyback programs. We find a higher 3-day cumulative abnormal return to programs announced by firms with better corporate governance practices than those with bad governance (1.6% and 0.85% respectively), and the market reaction is significantly higher following the successive scandals in year 2001 (Enron, Arthur Anderson, WorldCom…) and the resulting Sarbanes–Oxley Act of 2002. Further investigations indicate that firms with a lower Free Cash Flow to Asset ratio have a higher market reaction, which is consistent with the information signaling hypothesis, and this is more significant in firms with good governance practices, and following post Sarbanes–Oxley Act.

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Notes

  1. The Sarbanes–Oxley Act is also known as the Public Company Accounting Reform and Investor Protection Act of 2002 and commonly called Sarbanes–Oxley, Sarbox or SOX.

  2. See for example, Dann (1981), Vermaelen (1981), Asquith and Mullins (1986), Comment and Jarrell (1991), Li and McNally (2007), Lasfer and Andriosopoulos (2009), Klassen and Sivakumar (2001); and Kahle (2002).

  3. Other methods of distributing cash, such as dividends, debt-for-equity swaps, and leveraged recapitalizations, also alleviate agency problems. Compared to dividends, however, repurchases are tax advantageous to shareholders and do not imply the future commitment to returning cash to shareholders that is commonly associated with dividend increases. Repurchases are also more flexible and efficient than major leverage-increasing transactions such as debt-for-equity swaps and leveraged recapitalizations.

  4. The exchange theory differs from the signaling hypothesis as it is not used to signal current undervaluation, but rather gives the firm an option to repurchase shares in the future if the stock price drops below its real value. Stock price increase around the announcement comes in part from the value of the option itself.

  5. Comment and Jarrell (1991) showed that the reaction to the announcement of an open market repurchase program is characterized by an increase in share price of 2.3% in the US. Ikenberry et al. (1995) found an increase of 3.54% as a reaction to the announcement for the period ranging from 1980 to 1990. However, when more recent periods were considered, reactions seemed to have a lesser effect. Kahle (2002) observed a 1.61% increase over the three year period between 1993 and 1996. Klassen and Sivakumar (2001) calculated a mere 0.82% increase for the period spanning 1995-1999. Similarly, Li and McNally (2007) reported similarly a significant price reaction of 0.87% for Canada, for a 3-day cumulative trading-day window. Over the period spanning 1985-1998, Lasfer and Andriosopoulos (2009) calculated an increase of 1.64% in price reaction in the United Kingdom, and an increase of 1.06% in price reaction in the rest of Europe.

  6. See Power, The Wall Street Journal, March 7, 1995, “Heard on The Street Most Buybacks Are Stated, Not Completed,” pp. c1–c2.

  7. In the U.S, the legal and regulatory framework surrounding open market repurchase programs is relatively ambiguous. The only guide for executing open-market repurchases is SEC “safe harbor” rule 10b-18, part of the Exchange Act of 1934. This rule does not bind the firm to actually commit to the repurchase; it rather describes a code of conducts that protects firms against share price manipulation, when they repurchase their own stock from the market in accordance with the rule’s manner, timing, price and volume conditions. Prior to 2004, rule 10b-18 didn’t require any registration to be filed with the government or any stock market or exchange.

  8. Li et al. (2008) argue that investors expect that firms that had managed their earnings are likely to be constrained by SOX, which enhances the quality of financial statement information.

  9. According to Louis and White (2007), managers’ reporting behavior can be a major determinant of the value of the signal conveyed by the repurchase. Managers who conduct repurchases for non-signaling purposes are more likely to deflate earnings prior to the repurchase. The possibility of earnings management would decrease in well governed firms due to the enhanced quality of financial statement.

  10. A closer look at the database shows no significant difference in the CAR − 1/+ 1 between firms with low FCF-to-Assets and those with high FCF-to-Assets. However, the results show an average abnormal return of 1.4% for low cash firms that are well governed compared to an abnormal return of 0.56% for low cash firms that have bad governance practices. Moreover, the market reaction for low cash firms with good corporate governance is equal to 4.86% in the post governance crisis period, which is significantly higher than the 1.55% CAR observed by similar firms in the pre-SOX period (p = 1%).

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Acknowledgments

We are grateful to the seminar participants at the S. Olayan School of Business—the American University of Beirut, the editor, and three anonymous referees for their helpful comments on previous versions of this paper. Thanks also to Mazen Agha for his help in collecting the database. All errors are our own.

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  1. The Olayan School of Business, American University of Beirut, Bliss Street, Beirut, Lebanon

    Salim Chahine, Mohamad Jamal Zeidan & Hala Dairy

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  1. Salim Chahine
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  2. Mohamad Jamal Zeidan
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  3. Hala Dairy
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Correspondence to Salim Chahine.

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Chahine, S., Zeidan, M.J. & Dairy, H. Corporate governance and the market reaction to stock repurchase announcement. J Manag Gov 16, 707–726 (2012). https://doi.org/10.1007/s10997-011-9167-4

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