10

Share Buybacks and Other Transactions on Treasury Shares

Corporate and financial institutions with strong balance sheets and significant cash flows are tasked with capital-allocation decisions that require their executives to choose from an array of investment alternatives. These alternatives include the investment in their current businesses, the acquisition of other businesses and the return of capital to shareholders. The return of capital to shareholders via dividend distributions was the almost exclusive course of action in the 1970s. Another alternative is the return of capital via share repurchases. This alternative gained ground through the next two decades, and eclipsed dividend distributions during the dotcom revolution of the late 1990s and early 2000s. Share repurchases reflect a company's confidence in its long-term growth and profitability. In this chapter I will focus on share repurchases, or share buybacks, analyzing the main strategies used by companies engaged in these programs.

A company can purchase its own shares provided that it is authorized to do so by its articles of association (i.e., bylaws) and complies with certain statutory formalities. It must be authorized by the company's shareholders by an ordinary resolution. The authority commonly specifies the maximum number of shares which may be purchased, the maximum and minimum prices which may be paid and the date on which the authority will expire.

Normally, shares which are purchased by the issuer are cancelled. However, a company is permitted to hold own shares, subject to its legal limit (e.g., 10% of the company's issued ordinary share capital).

10.1 OPEN MARKET REPURCHASE PROGRAMS

One of the most common methods in share buybacks is to buy shares directly on the open market. Normally, the company targets a period (e.g., 12 months) during which either a number of shares would be acquired or a total cash amount would be spent. Under an open market repurchase (OMR) strategy, the treasury department is responsible for the execution of the repurchase. On a daily basis, the treasury executives follow the company's share price and give purchase orders to a stockbroker. The company executives may accelerate the targeted repurchase of shares when the shares experience a weak performance and delay the repurchase of shares when the shares experience a strong performance. In choppy markets with no overall direction, this strategy can be very interesting. An OMR strategy can help treasury executives to become more familiar with the company's share behavior, as on a daily basis these executives will follow the stock price movements, better understanding the forces behind these movements.

An OMR strategy can also be helpful to improve the liquidity of the stock when there are notably more sellers than buyers. This is, for example, the case of a shareholder selling a large block of shares. The company can buy the block, avoiding a sharp drop in its stock price. Similarly, when there is a large buying order on the market, the company can sell part of its own shares to avoid a large rise in its share price.

One of the major constraints of the OMR strategy is the impossibility of acquiring shares during blackout periods. These periods try to prevent the company and its executives from trading the company shares when sensitive information is known by the insiders but not yet by the market. For example, a blackout period may be set during the 20 days prior to an earnings release. Most blackout periods last at least 60 trading days per annum. It means that there are a substantial number of days that the company will not be able to take advantage of potential opportunities.

Another major weakness occurs in a strongly rising market. The executives involved in the OMR may prefer to delay the repurchases and wait for a potential upcoming correction. If the correction does not materialize, they may end up finally repurchasing the planned shares at a higher level, increasing the overall cost of the repurchase, besides causing unnecessary frustration and anxiety to the executives involved.

Market Abuse and Safe Harbours

Another major constraint of OMRs is that buy orders have to be executed in compliance with market abuse and safe harbour rules. Essentially market abuse rules try to avoid stock market manipulation. Regarding buybacks, the most relevant type of market abuse is effecting transactions or orders to trade, on own shares which give, or are likely to give, a false or misleading impression as to the supply of, or demand for, or as to the price of the company's stock, or to secure its price at an abnormal or artificial level. The primary purpose of safe harbour rules is to minimize market impact from a company's repurchases of own shares by limiting how, when, at what price and how many shares a company's common stock can be bought back. Safe harbour rules also protect a company from liability for market manipulation if the rules are followed when acquiring own shares. However, the mere fact that a buyback program does not fulfil the safe harbour requirements does not prevent a company from purchasing its own shares in the market. It can still do so in accordance with its buyback program as long its conduct does not amount to market abuse.

In some jurisdictions there are specific rules regarding buyback programs. For example, the EU has in place a regulation on buybacks and stabilization. Any purchase of own shares in accordance with these requirements will not constitute market abuse. This provides a safe harbor so far as market abuse is concerned.

Blackout Periods

In order to avoid abusing the market, most listed companies are prevented from purchasing own shares during blackout periods (also called “close periods”). The restrictions during blackout periods prevent a company from benefiting at the expense of stock market participants due to the possession of inside information. A blackout period usually starts one or two months preceding the announcement of preliminary and interim accounts, and ends on public disclosure of such accounts. Commonly, this restriction does not apply if the company has in place a buyback program managed by an independent third party which makes trading decisions in relation to the company's shares independently of, and uninfluenced by, the company.

Advantages and Weaknesses of an OMR Strategy

The advantages of an OMR strategy are the following:

• The company has complete flexibility to acquire the shares on the open market at its own discretion.
• The company benefits from a stock price decline.
• It helps treasury executives to become more familiar with the company's share behavior.
• It can help smooth imbalances in the trading of the company's stock. For example, the company can buy a block of shares offered by a shareholder, avoiding a sharp drop in its share price.
• The company avoids paying any premium for options or fees for delegated executions.

The disadvantages of an OMR strategy are the following:

• The company is exposed to a rising stock market. A steady climb in the stock price may substantially increase the cost of future share repurchases.
• The company has to devote resources to execute the shares repurchase.
• In most jurisdictions, the company cannot acquire own shares during blackout periods.
• Share purchases have to be carefully executed to comply with safe harbor rules.
• A bad timing of the execution, for example in an upward market followed by a sharply declining market, may cause the executives involved to be the subject of unfair criticism from shareholders.

10.2 ACCELERATED REPURCHASE PROGRAMS

From 2004, there has been a proliferation in the US of buyback programs executed under a strategy called accelerated stock repurchase (ASR). The main attraction of these programs is the rapid reduction of the number of shares outstanding. Next, I will analyze this type of transaction using a real case.

10.2.1 Case Study: Hewlett Packard's ASR with Merrill Lynch

In September 2004 Hewlett Packard (HP), the US electronics manufacturer, announced that it repurchased approximately USD 1.3 billion of its outstanding common stock. “HP has accelerated its share repurchases in recent quarters and today's announcement signals our intent to aggressively repurchase shares in the immediate future. We believe that at current price levels, HP shares represent an attractive investment”, said Carly Fiorina, HP's chairman and chief executive officer. The major aim of HP's share repurchasing programs was to minimize shareholder value dilution due to the exercise of employee options. The shares were purchased from Merrill Lynch under an ASR. Let us take a look at the building blocks of this ASR transaction (see Figure 10.1):

The Equity Forward

Prior to the forward maturity, HP could choose between cash and net share settlement. The settlement amount was calculated as:

The settlement price was the arithmetic average of the daily VWAP of HP stock during the life of the forward.

In case of cash settlement, two scenarios were possible:

• If the settlement price was greater than the USD 18.00 forward price and HP chose cash settlement, HP paid the settlement amount to Merrill Lynch. For example, if the settlement price was USD 19.00, HP would pay USD 71 million [= 71 million × (19.00 – 18.00)].
• Conversely, if the settlement price was lower than the USD 18.00 forward price and HP chose cash settlement, HP received the absolute value of the settlement amount from Merrill Lynch. For example, if the settlement price was USD 16.00, HP would receive USD 142 million [= Absolute value (71 million) × (16.00 – 18.00)].

Normally, HP would be choosing the net share alternative if it preferred not to pay (or receive) cash from Merrill Lynch. The number of shares to be delivered (or received) by HP would be calculated as follows:

• If HP had to deliver shares under the net share settlement alternative, HP and Merrill Lynch would agree on a period during which HP would be delivering shares to Merrill Lynch, and in turn, Merrill Lynch would sell these shares onto the open market. The execution will take place until the cumulative sale consideration equals the settlement amount. The net share price would then be the volume-weighted average selling price.
• Similarly, if Merrill Lynch had to deliver shares to HP under the net share settlement alternative, HP and Merrill Lynch would agree on a period during which Merrill Lynch would be buying shares in the market, and in turn, Merrill Lynch would deliver these shares to HP, until the cumulative sale consideration equals the settlement amount.

It can be inferred from the above that the combination of the purchase of shares at inception and the equity forward resulted in a repurchase price for HP equal to the arithmetic average of the daily VWAP of HP stock during the life of the forward.

Adjustments to Earnings per Share

The implementation of the ASR program immediately caused a decrease in the weighted-average number of shares assumed to be outstanding in calculating basic earnings per share. Because HP acquired the 71 million shares, this number of shares was immediately deducted from HP's shares outstanding.

During the life of the equity forward, an adjustment to the number of shares outstanding had to be performed when calculating the diluted earnings per share, to include the effects of a potential net share settlement of the equity forward, if such settlement was dilutive. In other words, if on a balance sheet date, the forward represented potential obligation to issue additional shares to Merrill Lynch, those additional shares had to be treated as issued and outstanding when calculating diluted earnings per share. To be dilutive, on the reporting date the arithmetic average of the VWAPs of HP stock since the forward inception had to be greater than the USD 18.00 forward price because under such a situation HP would have an additional obligation to deliver shares (under a net share settlement) to Merrill Lynch.

In our case, to simplify the analysis, we assumed that the equity forward had a sole 6-month maturity. Let us assume that on 31 December 2004, a financial reporting date, the arithmetic average of the VWAPs of HP stock since the forward inception was USD 19.00 and that HP's stock was trading at USD 20.00. If the forward were settled on that date and HP elected net share settlement, HP would deliver to Merrill Lynch 3.55 million [= 71 million × (19.00 – 18.00)/20.00] shares. As a consequence, HP had to take into account an additional 3.55 million shares when calculating the diluted earnings per share.

Advantages and Weaknesses of the ASR Strategy to HP

The advantages of HP's ASR strategy were the following:

• HP's share count was reduced immediately, improving earnings per share.
• HP benefited from a potential HP stock price decline subsequent to the ASR execution. The ASR locked in the average of the VWAPs of HP stock during the life of the forward.
• No premium was paid for options. The forward premium was zero.
• The forward contract was treated as an equity instrument under US GAAP. Any amounts (cash or shares) paid or received upon settlement of the contract were recorded directly in equity. Therefore, there was no income statement recognition. Beware that since 2004, US GAAP rules regarding the equity forward have varied.

The disadvantages of HP's ASR strategy were the following:

• HP was exposed to a potential stock price rise during the life of the equity forward.
• An aggressive purchase of stock by Merrill Lynch could put upward pressure on the stock price and therefore increase the actual repurchase price.
• The potential dilution, if any, calculated at each reporting date, reduced HP's diluted earnings per share.
• Merrill Lynch was not covered by the SEC's safe harbor provision at that time. The SEC ruled that ASRs and equity forwards were private transactions and not riskless principal trades effected on behalf of HP, and therefore, ineligible for the safe harbor provisions.

10.3 VWAP-LINKED REPURCHASE PROGRAMS

Under the OMR strategy, the company buys its own shares without a defined set of rules, resulting in a non-transparent repurchase price. Under the ASR strategy, the combination of the purchase of shares at inception and the equity forward resulted in a repurchase price for HP equal to the arithmetic average of the daily VWAP of HP stock during the life of the forward. However, this conclusion was not straightforward. VWAP-linked repurchase programs try to improve the transparency of buyback execution. The VWAP is a reliable and observable average price. It enables the company's stock holders to verify the quality of a share buyback program execution. A VWAP-linked strategy does not mean that the company loses all flexibility in acquiring shares; it can be complemented with opportunistic purchases via an OMR strategy during periods of a substantially weak stock price.

10.3.1 Execution on a Best Effort Basis

A way to implement a VWAP-linked repurchase strategy consists of the company delegating the execution to a stockbroker. The company and the broker would commonly agree on a number of shares to be acquired during a pre-agreed period. The broker then acquires shares on behalf of the company on a daily basis on the open market, trying to replicate the VWAP of such a day. The broker does not guarantee that the company would be buying the shares at the average of the daily VWAPs during the acquisition period. As a result, the company may be buying the shares during the acquisition period at a price higher or lower than the average VWAP.

The deviation between the realized purchase price and the average VWAP during the acquisition period is usually small because brokers usually use automatic execution programs that try to minimize these deviations. These programs also make sure that the execution complies with safe harbor rules. However, it causes substantial frustration and mistrust when a broker, day after day, reports to the company an acquisition price larger than the VWAP of such day.

It is not unusual that the company targets a cash amount to be spent instead of a number of shares to be acquired. The company and the broker would commonly agree on a daily amount of cash outlay to be spent during a pre-agreed period. The broker then acquires shares on behalf of the company on a daily basis on the open market, trying to replicate the VWAP of such day, spending the targeted cash amount. However, the achievement of the VWAP is not guaranteed by the broker. These types of execution have two major weaknesses:

• An execution based on a fixed cash amount is trickier for the broker than an execution based on a fixed number of shares. As a result, it is more difficult for the broker to achieve the daily VWAP.
• Even if the daily VWAP is achieved, the resulting average acquisition price will likely deviate from the arithmetic average of the daily VWAPs during the acquisition period. This likely deviation is due to the fact that the company acquires more shares when the stock price is low than when the stock price is high. As a result, when computing the arithmetic average of the VWAPs during a certain period, the shares acquired during a low price day will weight more than the shares acquired during a high price day, creating the earlier mentioned deviation. This weakness could largely be mitigated if the company targets a USD volume-weighted average VWAP instead of a simple arithmetic average VWAP.

10.3.2 Execution on a Guaranteed Basis

Another way to implement a VWAP-linked strategy is to have the executing broker to guarantee the average VWAP during the execution purchase period.

• In a transaction in which the number of shares to be acquired each day is pre-agreed, at the end of each trading day of the execution period the company will acquire the pre-agreed number of daily shares at the VWAP of such day.
• In a transaction in which the amount of cash to be spent each day is pre-agreed, at the end of each trading day of the execution period the company will acquire a number of shares at the VWAP of that day, such that the outlay equals the pre-agreed daily cash amount.

The broker then assumes the potential cost, or benefit, of any deviations of the realized acquisition price from the VWAP. As a compensation for bearing this risk, the company pays the broker a fee, for example 10 basis points (0.10%) of the total cash outlay.

10.3.3 Advantages and Weaknesses of a VWAP-linked Strategy

The advantages of a guaranteed VWAP-linked strategy are the following:

• The execution is transparent to all parties, including shareholders and research analysts, especially under guaranteed VWAP-linked strategies. This transparency avoids potential claims of poor execution from shareholders.
• The company benefits from a stock price decline.
• The company avoids paying any premium for options.
• The company usually delegates the execution to a stockbroker, avoiding devoting substantial internal resources to the repurchase program.
• Usually, the stockbroker can acquire shares during blackout periods. This is the case under irrevocable and non-discretionary buyback programs.

The disadvantages of a guaranteed VWAP-linked strategy are the following:

• It eliminates the company's flexibility to acquire the shares on the open market at its own discretion. However, a VWAP-linked strategy can be complemented with opportunistic purchases via an OMR strategy.
• The company is exposed to a rising stock market. A steady climb of the stock price may substantially increase the cost of future share repurchases.
• Share purchases have to be carefully executed to comply with safe harbor rules.
• The company usually has to pay a fee for the execution, especially under guaranteed VWAP strategies.

10.3.4 Execution at a Discounted VWAP

An interesting alternative is to enhance a guaranteed execution granting a right to the bank performing the execution. Usually, the right consists of the bank being able to terminate the share repurchase execution early on any trading day prior to the pre-agreed maximum maturity of the execution. For receiving this right, the bank would then compensate the company by assuring the acquisition of the shares at the average VWAP of the execution period minus a pre-agreed discount (e.g., 50 basis points). The amount of discount is dependent on, among other variables, the size of the transaction relative to the stock's average daily trading amount, the transaction's maximum maturity and the volatility of the stock. As an example, let us assume that the company targets a specific cash amount (the “notional amount”), to be spent under a VWAP-linked transaction with weekly settlements. The different steps of the transaction at inception would be the following:

During each weekly period, the steps would be the following (see Figure 10.2):

The transaction ends once the pre-agreed total cash amount to be spent under the transaction has been reached. At the transaction's end date:

Final Comments

If the company is indifferent about the term of a share repurchase execution, this strategy can be interesting. The main attractiveness is not only the guaranteed execution but also the discount to the average VWAP obtained.

However, this transaction has several weaknesses relative to a normal guaranteed VWAP execution:

• There are limitations in terms of size. Very large buybacks relative to the stock's average daily volume will be priced with an unattractive discount because they provide little flexibility in shortening the execution's term.
• The bank has entire flexibility on the cash spent periodically (weekly in our example). A concentration of purchases in some weeks may require the company to pay a larger than expected cash amount for the shares.
• As the transaction is notably structured, its unwind can be costly. Sometimes, the company wants to terminate the transaction early because the shares are trading at an unattractively high price.

10.3.5 Execution at a Capped VWAP

An interesting alternative is to enhance a guaranteed execution by capping the average VWAP. The bank has the right to accelerate the completion of the share repurchase execution in exchange for providing the company with a cap on the average VWAP. Therefore, the company is guaranteed a maximum repurchase price. The cap level is pre-agreed at inception and is established as a percentage (e.g., 120%) of the initial price.

The steps are similar to the steps of the “discount to the VWAP” strategy. There are only two differences relative to the process previously outlined for the discounted VWAP strategy (see previous subsections):

• The bank needs to put in place an initial hedge, by buying a number of the company's shares in the market. The volume-weighted average price at which the bank acquires the shares corresponding to the initial hedge becomes the initial price. Once the initial price is known, the cap is then known. The company would represent that it is not in possession of any material non-public information during the initial hedging period used to determine the initial price.
• At the end of the execution the final price would be calculated as follows:

As an example, let us assume that ABC, a US-based company, enters into an execution agreement with Gigabank. Under the agreement, ABC would end up buying USD 200 million worth of own shares. ABC's stock is trading at USD 10.00 at inception. Gigabank guarantees that the repurchase price would be the arithmetic average of ABC's VWAP during the execution period, subject to a maximum repurchase price of USD 12.00. Gigabank is required to execute the share repurchase during a maximum period of 9 months. Gigabank can accelerate the completion of the execution. To illustrate the mechanics of the strategy, I have assumed two scenarios:

Under the first scenario, ABC's decision to enter into the capped VWAP strategy was a great one. ABC repurchased 16.67 million shares. Without the cap, and assuming an execution matching the average VWAP, ABC would have repurchased 14.08 million (= 200 million/14.20) shares.

Under the second scenario, ABC would have been better off entering into a discounted VWAP strategy. Assume that the discount would have been 50 basis points. Under a discounted VWAP strategy, ABC would have repurchased 17.95 million [= 200 million/(11.20 × (1 – 0.50%)] shares. As we just saw, under the capped VWAP strategy, ABC acquired 17.86 million shares.

10.4 PREPAID COLLARED REPURCHASE PROGRAMS

The main weakness of the standard ASR analyzed earlier was that HP was exposed to an increase in its stock price. A stock price rise was likely given the fact that Merrill Lynch had to buy 71 million shares during the six-month life of the ASR and that HP also acquired a substantial amount of shares in the open market. Prepaid collared repurchase programs (PCRPs) try to mitigate this exposure by capping the VWAP over the time period that the transaction remains outstanding. To avoid the payment of an upfront premium, PCRPs also include a floor on the VWAP over the transaction term. In essence, a PCRP is a collared VWAP-linked transaction. In the PCRP that I am going to analyze next, the collar is applied to the average VWAP of each weekly period, instead of applying only to the overall average VWAP during the transaction term.

10.4.1 Case Study: Hewlett Packard's PCRP with BNP Paribas

On 14 February 2006, HP's board of directors authorized USD 4 billion for future repurchases of HP's outstanding shares of common stock. This buyback aimed to offset potential dilution under its employee stock option and share ownership plans. Instead of offsetting dilution upfront with an ASR, HP was more interested in offsetting dilution as it occurred. One alternative was to wait until dilution happened to offset it by repurchasing shares from the market that mirrored the number of options exercised. However, under this alternative HP was exposed to a rising stock price. If HP's stock price went up it would be buying shares at a rising price, incurring in a higher cost. To make things worse, the higher the stock price, the higher the number of stock options exercised by their beneficiaries. Other alternatives included the purchase of in-the-money calls or call spreads, but they required a substantial upfront premium. Instead, HP decided to enter into a collar-type structure, buying a string of calls and selling a string of puts, at no cost.

In March 2006, HP and BNP Paribas entered into a PCRP. HP called the deal a “prepaid variable repurchase” transaction on USD 1.716 billion. The PCRP allowed HP to cap the price paid per share and to impact shares outstanding evenly over time. The building blocks of the transaction at inception were the following:

On a weekly basis over the one-year term of the PCRP, and assuming 52 weeks over the one-year term:

Therefore, the USD 1.716 billion paid by HP to BNP Paribas at the beginning of the transaction represented one million shares during 52 weeks at USD 33.15, the highest price per share HP had to pay under the agreement.

The PCRP Agreement

At inception of the PCRP, HP paid to BNP Paribas USD 1.716 billion. Under the PCRP, BNP Paribas agreed to deliver to HP between 1 million and 1.34 million HP shares every week over the course of a year. The exact number of shares to be repurchased was based upon the VWAP of HP's shares during each weekly settlement period, subject to the minimum and maximum price as well as regulatory limitations on the number of shares HP was permitted to repurchase. The minimum and maximum prices per share were USD 24.60 and USD 33.15, respectively. These prices were pre-agreed at inception of the transaction. As a result, the minimum and maximum number of shares HP could receive under the program was 52 million shares (i.e., one million shares per week) and 70 million shares (i.e., 1.34 million shares per week), respectively. HP decreased its shares outstanding each weekly settlement period as it physically received shares.

From an accounting point of view, HP initially recorded the USD 1.7 billion payment as a prepaid stock repurchase in the stock holders’ equity section of its balance sheet, and in the cash flows from financing activities of its statement of cash flows. The prepaid funds were expended rateably over the term of the program.

Advantages and Weaknesses of the PCRP Strategy to HP

The advantages of HP's PCRP strategy were the following:

• HP was not exposed to a stock price above USD 33.15.
• HP did benefit from a stock price decline over the term of the PCRP down to USD 24.60.
• Share count was reduced gradually over the term of the PCRP, following more closely the timing of the dilution generated by the exercises of HP's stock option programs. This was one of the initial objectives of HP. However, it could be argued that for the stock it is better to have an upfront reduction in the number of shares outstanding, like the one generated by ASRs.
• No premium was paid for options.
• The PCRP was treated as an equity instrument under US GAAP. The upfront amount and any number of shares received upon the weekly settlements of the contract were recorded directly in equity. Therefore, there was no income statement recognition. Beware that US GAAP rules regarding the transaction may have varied.
• The implied volatilities of the puts HP sold were greater than the volatility of the calls it purchased through the collar.

The disadvantages of HP's PCRP strategy were the following:

• HP was exposed to a potential HP stock price rise over the term of the PCRP, up to USD 33.15.
• HP did not benefit from a stock price below USD 24.60.
• HP had to advance USD 1.716 billion to cover the future cost of the share repurchase.
• At inception, BNP Paribas had to buy a large number of HP shares to hedge its collar position, because the bank was long a string of puts and short a string of calls. This initial purchase gave an additional momentum to HP's stock price, potentially increasing the floor and the cap levels of the PCRP and the costs of future share repurchases.
• BNP Paribas was not covered by the SEC's safe harbor provision at that time. The SEC ruled that ASRs and equity forwards, and thus also PCRPs, were private transactions and not riskless principal trades effected on behalf of HP, and therefore, ineligible for the safe harbor provisions.

10.5 DEEP-IN-THE-MONEY CALL PURCHASE

As seen earlier, a company executing a buyback program is exposed to a rising stock price. Usually, companies target a cash amount to be spent in acquiring own shares under a buyback program. A rising stock price means that the company would end up buying a lower number of shares than expected. An alternative for a company is to buy call options on its own stock to mitigate this exposure. The call will hedge the company against a rise in its share price.

10.5.1 Case Study: ABC's Acquisition of a Deep-in-the-money Call Option

Let us assume that ABC targeted to repurchase USD 600 million of its outstanding common stock over the next 12 months and that ABC's stock price was trading at USD 10.00. Thus, ABC planned to spend USD 50 million (= 600 million/12) per month. ABC was worried that its stock price could rally during the next 12 months, causing it to acquire a number of shares lower than expected. In order to lock in a maximum price per share, ABC considered purchasing a call option.

At-the-money Call versus Deep-in-the-money Call

First, ABC considered buying a string of at-the-money calls (i.e., with strike price 100% of ABC's USD 10.00 initial stock price). ABC would enter into 12 calls, expiring at the end of each of the next 12 monthly periods. The underlying number of shares to each call option was 5 million (= 50 million/10.00). The options were physically settled. The overall premium was 8% of its notional amount, or USD 48 million (= 8% × 60 million × 10.00), or EUR 0.08 per share. Thus, ABC's stock price had to be at maturity above USD 10.80 [= 10.00 × (1 + 8%)] for this strategy to be profitable. The overall delta of this string of call options was 53%.

Next, ABC considered buying a string of deep-in-the-money calls with a strike price of USD 7.00 (i.e., 70% of ABC's USD 10.00 initial stock price). ABC would enter into 12 calls, expiring at the end of each of the next 12 monthly periods. The underlying number of shares to each call option was 5 million. The options were physically settled. The overall premium was 32% of its notional amount, or USD 192 million (= 32% × 60 million × 10.00). ABC's stock price had to be at maturity above USD 10.20 [= 10.00 × (70% + 32%)] for this strategy to be profitable. The overall delta of this option was 90%.

Let us compare the two call option strategies (see Figure 10.5):

• The breakeven stock price of the deep-in-the-money call alternative (USD 10.20) was lower than that of the at-the-money call alternative (USD 10.80). This was because the time value of the former alternative was only 2% (= 70% + 32% – 100%), while the time value of the latter was 8% (= 100% + 8% – 100%).
• The premium of the deep-in-the-money call alternative was much larger than that of the at-the-money call alternative. ABC had to pay a USD 192 million premium to acquire the deep-in-the-money call, while the premium of the at-the-money call was USD 48 million.
• As a result of the previous two elements, premiums and strikes, the deep-in-the-money call alternative outperformed the at-the-money call alternative when ABC's stock price was greater than USD 9.40. Conversely, the deep-in-the-money call alternative underperformed the at-the-money call alternative when ABC's stock price was lower than USD 9.40.
• The delta of the deep-in-the-money call alternative (90%) was much larger than the delta of the at-the-money call alternative (53%). To initially hedge its position, Gigabank needed to buy 54 million (= 60 million × 90%) ABC shares at inception of the deep-in-the-money call strategy. However, to initially hedge its position under the at-the-money call Gigabank needed to buy 31.8 million (= 60 million × 53%) ABC shares. Therefore, the implementation of the deep-in-the-money call strategy took longer than that of the at-the-money call strategy. Remember that the strike prices were set as a percentage of the volume-weighted average price per share at which Gigabank acquired the shares necessary to implement its initial hedge. Consequently, ABC was exposed to a share price rise until Gigabank ended executing its initial hedge.

In my view, for cash-rich companies it makes sense to buy deep-in-the-money calls rather than at-the-money calls. As this was ABC's situation, it acquired the following string of calls:

Physically Settled Call Options – Main Terms
Buyer	ABC Corp.
Seller	Gigabank
Option type	Call
Trade date	1-October-20X1
Expiration date	12 expiries. The 10th of each month starting on November 20X1 and ending on October 20X2
Option style	European
Shares	ABC Corp.
Number of options	5 million per expiry (i.e., 60 million in total)
Strike price	USD 7.00 (set as 70% of the initial price)
Initial price	The volume-weighted average price per share at which Gigabank acquires the shares necessary to implement its initial hedge. The initial price was set to USD 10.00
Total premium	USD 192 million (32% of the option notional amount)
Notional amount	USD 600 million (= 60 million × 10.00)
Premium payment date	12-October-20X1
Settlement method	Physical settlement only
Settlement date	Three exchange business days after the exercise date

At each expiry, there were two scenarios:

• If ABC's stock price was greater than the USD 7.00 strike price, ABC would exercise the call, buying 5 million own shares at USD 7.00 per share. ABC would spend USD 35 million (= 5 million × 7.00).
• If ABC's stock price was lower than, or equal to, the USD 7.00 strike price, ABC would not exercise the call. Instead, ABC would be buying in the market a number of shares equal to: USD 35 million/stock price. For example, if ABC's stock price was USD 6.00, ABC would purchase 5.83 million (= 35 million/6.00) shares. The shares would be acquired in the market at the then prevailing stock price.

One major problem with this strategy is that if a monthly call option was not exercised, ABC would be obliged to acquire the 5 million monthly shares in the market. If it was able to acquire the shares on the closing at the end of the monthly period, there was no risk for ABC. However, if the number of shares was substantial (a very frequent situation), ABC would need to buy the shares during the next several days after the call expiry date to avoid having a strong effect on its stock price. In this situation, ABC was exposed to a rising stock price until the 5 million shares were acquired in the market.

Advantages and Weaknesses of a Deep-in-the-money Call Purchase Strategy

The advantages of a deep-in-the-money call purchase strategy are the following:

• The company is not exposed to an increasing stock price.
• The company benefits from a stock price decline.
• By buying deep-in-the-money, the company avoids paying a large amount of time value. The total value of a deep-in-the-money call strategy is almost entirely comprised of its intrinsic value.
• The company sends the market a positive signal regarding its share price.

The disadvantages of a deep-in-the-money call purchase strategy are the following:

• The company has to pay a large upfront premium.
• The stock price must be greater than the strike price by the premium to breakeven.
• The company is subject to a risk between the average daily price and the monthly closing price, unless it is able to acquire all the monthly shares at the end of its related monthly period.
• The bank selling the option has to buy a large number of shares at inception, potentially giving additional upward momentum to the stock price. This may substantially increase the cost of future share repurchases.

10.6 ASIAN CALL PURCHASE

Let us assume that ABC did not have the resources to acquire a string of deep-in-the-money calls, and that it was considering the purchase of a string of at-the-money calls. As we saw in the previous section, the premium was substantial, USD 40 million. The objective of this strategy was to limit the repurchase price of its monthly buyback requirements over a year to EUR 10.00 per share (ignoring the premium). Although buying the string of at-the-money calls met ABC's objective, ABC was overprotected. For example, if one month ABC was paying EUR 12.00 and another month it was paying EUR 8.00, the average purchase price was EUR 10.00 [= (12.00 + 8.00)/2]. Under the string of calls, ABC would have paid EUR 9.00 [= (10.00 + 8.00)/2]. Thus, ABC was not worried about each month acquiring shares below EUR 10.00. Instead, ABC was worried about an overall repurchase price exceeding EUR 10.00.

An Asian call (an Asian average rate call) is a type of option where the payoff is computed taking into account the average of the underlying stock price during a period. For example, ABC could have entered into the following Asian call:

Cash-settled Asian Call Options – Main Terms
Buyer	ABC Corp.
Seller	Gigabank
Option type	Call
Trade date	1-October-20X1
Expiration date	10-October-20X2
Option style	Asian
Shares	ABC Corp.
Number of options	60 million
Strike price	USD 10.00 (set as 100% of the initial price)
Initial price	The volume-weighted average price per share at which Gigabank acquires the shares necessary to implement its initial hedge. The initial price was set to USD 10.00
Final price	The arithmetic average of the daily closing prices of the shares from 10-October-20X1 to 9-October-20X2 (both included). Only exchange business days would be included in the calculation
Total premium	USD 36 million (6% of the option notional amount)
Notional amount	USD 600 million (= 60 million shares × 10.00)
Premium payment date	12-October-20X1
Settlement method	Cash settlement only
Settlement date	Three exchange business days after the exercise date

The call would be settled in cash. The settlement amount was calculated as follows:

The final price was computed as the arithmetic average of the closing prices of ABC stock during the annual period. As an example, let us assume that ABC's stock price behavior during the 12-month period was that depicted in Figure 10.6. The average closing price over the 12-month period was EUR 11.80. The settlement amount was then EUR 108 million [= 60 million × (11.80 – 10.00)].

The Asian call strategy had two strengths relative to the at-the-money standard call option strategy. Firstly, the premium was lower (USD 36 million vs. USD 48 million). Secondly, it allowed ABC to acquire the shares in the market on a daily basis. If it acquired 250,000 (= 5 million/20) shares in the market each trading day, assuming 20 trading days in the month, ABC was perfectly hedged with the Asian option.

10.7 PUBLICLY OFFERED REPURCHASE PROGRAMS

One way to implement a repurchase program in a very transparent manner is to acquire own shares via a public repurchase offer. Under this strategy all shareholders are given an identical opportunity to benefit from a buyback. The offer solicitation provides for a submission period, the number of shares the company intends to acquire, the offer price and other terms and conditions. The company may in its solicitation either state that:

• The purchase price is fixed.
• Or, the purchase price would be determined by way of an auction procedure. In this case, the company usually states a range within which offers may be submitted. Typically, the solicitation usually includes the possibility of adjusting the price range during the submission period if, after publication of the solicitation, offer and demand show important imbalances or if significant share price fluctuations occur during the submission period. Upon acceptance, the final purchase price will be determined from all the submitted sale offers.

If the number of company shares offered for sale exceeds the total volume of shares the company intended to acquire (i.e., the offer is oversubscribed), acceptance is commonly based on quotas. Furthermore, the company may provide for preferred acceptance of small lots of shares.

10.7.1 Case Study: Corporacion Dermoestetica's Public Offer to Acquire Own Shares

This case highlights how Corporacion Dermoestetica (“Dermoestetica”), a Spanish plastic-surgery provider, successfully completed its share buyback by offering to buy back own shares from all its shareholders.

In July 2009, Dermoestetica planned to acquire 47.4% of its shares at EUR 5.50 per share, a 74% premium to the stock closing price prior to the buyback announcement. The buyback would be implemented via a public cash offer to all Dermoestetica's shareholders. The buyback aimed to distribute part of Dermoestetica's sale proceeds of the British laser-eye provider Ultralase Ltd. Immediately following the announcement, Dermoestetica's stock price surged 46% to EUR 4.60.

In September 2009, the offer was accepted by 90% of the shareholders. Because the accepted sale orders exceeded the maximum number of shares to be repurchased, a pro rata adjustment factor of 52.9% was applied to the sale orders. In October 2009, the repurchased shares were amortized.

In practice, this transaction was equivalent, before any taxes were levied, to a special dividend. The decision to distribute excess cash via a share repurchase instead of a special dividend was due to the following:

• The company took advantage of a depressed stock price. Since its IPO at EUR 9.10 in July 2005, Dermoestetica's stock price had been declining. A purchase at EUR 5.50 signaled the market that the company viewed its stock price as notably cheap.
• The reduction in the number of shares outstanding meant that the company would distribute fewer ordinary dividends in the future, if the dividend policy was unchanged. Therefore, the company was able to save future cash resources.
• The earnings per share were greatly improved by the share buyback.
• The share buyback probably had a tax advantage for the selling shareholders. As I mentioned earlier, the selling shareholders probably realized a capital loss. A special dividend would probably have meant that Dermoestetica's retail shareholders would be levied a withholding tax.

10.8 PUBLIC OFFER OF PUT OPTIONS

One way to implement a repurchase program is to publicly offer a put option to all shareholders.

10.8.1 Case Study: Swisscom's Public Offer of Put Options

This case highlights how Swisscom, a Swiss telecommunications company, successfully completed its share buyback by issuing tradeable put options to all its shareholders. Following Swisscom's AGM in April 2006 approving a CHF 2.2 billion buyback program, the company's board of directors approved a public offering of put options to its shareholders. The proposed structure was intended to treat all shareholders equally by giving them a right to sell part of their shares to the company at a premium to the then prevailing stock price.

The put options were assigned to shareholders free of charge on 30 August 2006 with an exercise date of 13 September 2006. 23 put options entitled the bearer to sell two registered shares for CHF 450 gross or CHF 292.85 net per share (less 35% federal withholding tax on the difference between the share buyback price and the par value). The options were traded from 30 August to 12 September 2006 on the Swiss stock exchange. The options could be exercised on 13 September 2006. Alternatively, the put options could be sold on the exchange during their trading period. The following table highlights the key details of the offering:

Swisscom's Public Offer of Put Options – Main Terms
Allocation of put options	One put option for each Swisscom share. The put options will automatically be booked to the custody accounts of Swisscom shareholders on 30 August 2006
Option trading	The put options may be freely traded for a period of 10 trading days starting 30 August 2006
Exercise ratio and strike price	If exercised, 23 put options entitle the holder to sell two Swisscom shares at a gross price of CHF 450 per share
Option type	European (can only be exercised at maturity)
Exercise of put options	13 September 2006, until 12.00 noon (CEST). Put options not exercised in time, and the rights associated with them, shall expire without compensation
Payment of the buyback price	If the put options are exercised, the net buyback price will be paid out on delivery of the corresponding number of Swisscom registered shares and put options on 18 September 2006
Listing of the put options	The put options are to be listed on 16 August 2006. They will be traded on the SWX Swiss Exchange from 30 August to 12 September 2006
Costs	The costs of allocating and exercising put options deposited with banks in Switzerland will be borne free of charge by Swisscom (but not the fees for the sale of options or the purchase of additional options)

Of the 56,718,561 put options issued, 56,541,107 or 99.69% were exercised. Swisscom thus bought back 4,916,618 of its own shares for the capital reduction, which was equivalent to 8% of voting rights and share capital recorded. The share buyback volume amounted to CHF 2.2 billion.

This solution was implemented because Swisscom's largest shareholder, the Swiss government, was looking to dispose of its stake. The structure used allowed it to sell part of its stake in a transparent manner. Before the buyback, the Swiss government owned 62.5% of Swisscom's share capital. Upon completion of the buyback, the Swiss government owned 53.9% of Swisscom's share capital.

10.9 PRIVATE SALE OF A PUT OPTION

An exotic way of implementing a repurchase of stock is to sell a put option to a bank. Let us assume that ABC sold a put option to Gigabank with the following terms:

Physically Settled Put Option – Main Terms
Seller	ABC Corp.
Buyer	Gigabank
Option type	European put
Trade date	1-June-20X1
Expiration date	1-June-20X2
Shares	ABC Corp.
Number of options	20 million (one share per option)
Strike price	USD 10.00 (100% of the spot price)
Spot price	USD 10.00
Premium	8% of the notional amount, or USD 16 million (i.e., USD 0.8 per share)
Premium payment date	3-June-20X1
Notional amount	USD 200 million (i.e., Number of options × Spot price)
Settlement method	Physical settlement
Cash settlement payment date	4-June-20X2

Shortly after inception, i.e., on 3 June 20X1, ABC received a USD 16 million premium from Gigabank. This premium represented USD 0.80 per share.

At expiry, on 1 June 20X2, two scenarios could occur:

• If XYZ's stock price was greater than or equal to the USD 10.00 strike price, the option would expire worthless. Overall ABC would have received the USD 16 million premium, enhancing other open market repurchases by USD 0.80.
• If XYZ's stock price was lower than the USD 10.00 strike price, ABC would receive from Gigabank 20 million shares in exchange for the payment of EUR 200 million. Taking into account the 0.80 per share upfront premium, ABC would have repurchased 20 million own shares at USD 9.20 each.

This is a very opportunistic strategy that can be used to complement other repurchase strategies. Otherwise, ABC may end up being exposed to a rising price without being able to repurchase the shares until the put's expiration date.

Advantages and Weaknesses of a Put Sale Strategy

The advantages of a put sale strategy are the following:

• The company receives a large upfront premium.
• Upon disclosure, the company conveys a positive view on its stock price.

The disadvantages of a put sale strategy are the following:

• The company is exposed to an increasing stock price.
• The company does not benefit from a stock price decline.
• The bank buying the put option has to buy a large number of shares at inception, potentially giving additional upward momentum to the stock price. This may substantially increase the cost of future share repurchases.

10.10 ACQUISITION OF SHARES WITH A RANGE ACCRUAL

10.10.1 One-speed Range Accrual

In the following sections, I will cover a popular way to buy own shares at a discount. Range accrual instruments allow the daily purchase of shares at a discount to the stock price prevailing at the strategy's inception. There are many versions of this strategy. I will review next the one-speed range accrual instrument. The selling version was covered in Chapter 6.

Let us assume that ABC targeted to repurchase USD 600 million of its outstanding common stock over the next 12 months and that ABC's stock price was trading at USD 10.00. ABC was interested in acquiring shares at a discount, and as a result, entered into the following one-speed range accrual:

One-speed Range Accrual – Main Terms
Buyer	ABC Corp.
Seller	Gigabank
Option type	Range accrual
Trade date	1-June-20X1
Start date	7-June-20X1
Maturity date	7-June-20X2 (1 year)
Shares	XYZ common stock
Maximum number of shares	65.2 million
Initial price	The volume-weighted average sale price per share at which the seller (Gigabank) puts in place its initial hedge
Strike price	USD 9.20 (92% of the EUR 10.00 initial price)
Barrier	USD 10.80 (108% of the EUR 10.00 initial price)
Premium	None
Accrual periods	Each monthly period from, and including, the start date to, and including, the maturity date
Number of shares	For each accrual period: 260,000 × Number of days
Number of days	The number of trading days during the monthly period that the closing price of the shares is lower than, or equal to, the barrier
Settlement method	Physical settlement The buyer shall acquire from the seller the number of shares at a price per share equal to the strike price
Settlement date	Three exchange business days immediately following the end of the corresponding monthly period

The different steps of the transaction during its life are the following (see Figure 10.7).

On trade date, ABC and Gigabank agreed on the terms of the range accrual. The strike price and the barrier were defined as a percentage, 92% and 108% respectively, of the initial price. The maximum number of shares, 65.2 million, was determined by dividing (i) the buyback's USD 600 million target amount by (ii) the USD 9.20 strike price. The number of shares for each monthly accrual period was calculated by multiplying (i) 260,000 and (ii) the number of trading days during the monthly period that the closing price of the shares was lower than, or equal to, the barrier. The 260,000 figure represented the maximum number of shares that could accrue on a trading day and was determined by dividing (i) the 65.2 million shares by (ii) 250 trading days from start to maturity date.

Starting on the trade date (1 June 20X1), Gigabank put in place its initial hedge by buying a number of ABC shares in the market. Gigabank finished the initial hedge execution on the start date (7 June 20X1). The initial price, USD 10.00, was the volume-weighted average price at which Gigabank acquired the necessary ABC shares to establish its initial hedge. As a result, on trade date the strike price and the barrier were respectively set at USD 9.20 and USD 10.80.

The one-speed accrual allowed ABC to buy own shares at USD 9.20, an 8% discount to the initial price. The maximum number of shares that ABC could end up buying was 65.2 million. Assuming 250 trading days over the one-year term of the transaction, each trading day ABC could accrue a maximum of 260,000 shares.

The 12-month term of the transaction was divided into 12 monthly periods (the “accrual periods”). On each trading day of the accrual period, the number of shares accruing that day was a function of the closing price of ABC's stock on that day (see Figure 10.8):

• If the stock closing price was lower than, or equal to, the USD 10.80 barrier, 260,000 shares accrued that day.
• If the stock closing price was greater than the USD 10.80 barrier, no shares accrued that day.

Three exchange business days following the end of the monthly accrual period (the “settlement date”), ABC purchased from Gigabank the aggregate of the accrued shares during the accrual period. The accrued shares were acquired at USD 9.20 per share.

In order to highlight the strengths and weaknesses of the strategy, let us assume three different price performances of ABC's stock price during the life of the instrument (see Figure 10.9):

• Under the first scenario, ABC's stock price experienced a strong rally. Excluding the first few months, the stock traded above the USD 10.80 strike. As a result, only 16 million shares were accrued, and therefore acquired, over the term of the instrument. ABC was relatively satisfied with the range accrual performance because it was able to buy the shares at USD 9.20, while the stock traded well above this level during most of its term. At the end of the instrument's life ABC only spent USD 147.2 million (= 16 million × 9.20), acquiring own shares. ABC spent the remaining USD 452.8 million (= 600 million – 147.2 million) acquiring shares in the market at the then prevailing stock price.
• Under the second scenario, ABC's stock price experienced a performance without an overall direction. Because ABC's stock price always traded below the USD 10.80 barrier, all the 65.2 million shares were accrued, and therefore acquired, over the term of the instrument. ABC was very satisfied with the range accrual performance because it was able to acquire the shares at USD 9.20, while the stock traded above this level during all the life of the instrument.
• Under the third scenario, XYZ's stock price experienced a strong correction. Because the stock price always traded below the USD 10.80 strike, all the 65.2 million shares were accrued, and therefore acquired, over the term of the instrument. However, ABC was not entirely satisfied with the range accrual strategy because it acquired the shares at USD 9.20. It is true that this price was an 8% discount to the initial price. However, without entering into the instrument ABC could have obtained a lower overall acquisition price in the market.

Advantages and Weaknesses of the Strategy

The advantages of this strategy were the following:

• ABC acquired the accrued shares at a discount to the initial price.
• ABC benefited from each day that the stock price traded between the USD 9.20 strike price and the USD 10.80 barrier.
• ABC had complete flexibility to pursue other strategies on the shares that were not accrued.

The disadvantages of this strategy were the following:

• ABC had no certainty regarding the number of shares to be acquired. Purchases took place only if ABC's stock price was below the USD 10.80 barrier.
• ABC did not benefit from a stock price below the USD 9.20 strike price.
• ABC was exposed to a future rise of ABC's stock price.
• The range accrual was accounted for as a derivative. ABC fair valued the instrument through the income statement.
• This was not the case, but a range accrual may be feasible only for a limited number of shares. This limitation may require the company to implement another buyback strategy.

Building Blocks

From ABC's viewpoint, the one-speed range accrual was built by combining a purchased knock-out call and a short put. Each trading day over the term of the range accrual, a combination expired on such day, as follows (see Figure 10.10):

• ABC sold a string of put options with strike price USD 9.20 on 260,000 ABC shares. There was a put for each trading day of the 12-month period (i.e., 250 puts). In other words, only one put expired on each day of the 12-month period.
• ABC bought a string of call options with strike ABC 9.20 on 260,000 XYZ shares. There was a call for each trading day of the 12-month period (i.e., 250 calls). In other words, only one call expired on each day of the 12-month period. Each call ceased to exist if, on its expiry date, ABC's stock price was above the USD 10.80 barrier. Therefore, this option was a knock-out call.

10.10.2 Double-speed Range Accrual

A variation available to ABC was to enter into a range accrual with double speed. The first objective was to reduce the purchase price from USD 9.20 to EUR 8.50. Therefore, any shares sold through the double-speed range accrual instrument were sold at a 15% discount to the initial price. A second objective was to expand the ranges in which shares accrued. Under the one-speed range accrual, ABC's stock price had to trade below USD 10.80 to accrue some shares on an observation day. Under the two-speed range accrual, ABC's stock price had to trade above USD 11.50 to accrue some shares on an observation day. However, these two objectives were achieved in exchange for including a middle range in which just 130,000 shares accrued.

The mechanics of the double-speed range accrual are similar to the one-speed range accrual. The only difference lies in the daily accrual mechanism. As we saw earlier, the 12-month term of the transaction was divided into 12 monthly periods (the “accrual periods”). On each trading day of the accrual period, the number of shares accruing that day was a function of the closing price of ABC's stock on that day (see Figure 10.11):

• If the stock closing price was lower than the USD 8.50 strike price, 260,000 shares accrued that day.
• If the stock closing price was lower than, or equal to, the EUR 11.50 barrier and greater than, or equal to, the USD 8.50 strike price, 130,000 shares accrued that day.
• If the stock closing price was greater than the USD 11.50 barrier, no shares accrued that day.

At the end of each monthly period, the accrued shares were bought by ABC from Gigabank at the USD 8.50 strike price.

Comparison to the One-speed Range Accrual

If we compare the two-speed range accrual with the one-speed range accrual, the performance of one strategy relative to the other depends on ABC's stock price behavior:

• In a very weak stock market from start, the two-speed range accrual is likely to outperform. Although a similar number of shares would be accrued under both instruments, however, the shares bought under the two-speed range accrual would be acquired at USD 8.50 instead of at USD 9.20.
• In moderately positive, or moderately negative, stock market behaviors, the one-speed range accrual is likely to outperform. A much larger number of shares are likely to accrue under the one-speed range accrual. The fact that the shares are bought at a higher price than in the two-speed version will be more than compensated by the larger number of shares bought.
• In a notably strong market from the beginning, the two-speed range accrual is likely to outperform as it will take longer to reach the barrier level.

Building Blocks

From ABC's viewpoint, the two-speed range accrual was built by combining a purchased knock-out call and a short put. Each trading day over the term of the range accrual, a combination expired on such day, as follows (see Figure 10.12):

• ABC sold a string of put options with strike price USD 8.50 on 260,000 ABC shares. There was a put for each trading day of the 12-month period (i.e., 250 puts). In other words, only one put expired on each day of the 12-month period.
• ABC bought a string of call options with strike ABC 8.50 on 130,000 XYZ shares. There was a call for each trading day of the 12-month period (i.e., 250 calls). In other words, only one call expired on each day of the 12-month period. Each call ceased to exist if, on its expiry date, ABC's stock price was above the USD 11.50 barrier. Therefore, this option was a knock-out call.

10.10.3 Double-speed Range Accrual with Final Put

Another popular version of the range accrual instrument is a range accrual with a final put. Let us take the previous section's two-speed range accrual. This range accrual had a strike price set at USD 8.50 (a 15% discount to the initial price) and a barrier at USD 11.50. By including the sale of a put and maintaining the barrier unchanged, the strike price could be set at USD 8.20 (an 18% discount to the initial price). The put gave Gigabank the right, but not the obligation, to sell at maturity at the strike price all the unaccrued (and thus unsold) shares during the 12-month tenor of the instrument.

As an example, let us assume that out of the maximum 62.5 million shares, ABC bought 42.5 million shares through the accrual process during its 12-month duration. At maturity, Gigabank had the right to sell to ABC 20 million (= 62.5 million – 42.5 million) shares at USD 8.20. Therefore:

• If, at maturity, ABC's stock price was lower than USD 8.20, Gigabank would exercise the put and ABC would buy from the bank 20 million shares at USD 8.20. ABC would then have bought all its target 62.5 million ABC shares.
• If, at maturity, ABC's stock price was greater than, or equal to, USD 8.20, Gigabank would not exercise the call. Then, ABC would need to acquire 20 million own shares in the market.

The improvement in strike price caused by the inclusion of the put, from a 15% discount to an 18% discount, was not very large. Why didn't it result in a lower strike price? This was because a stock price at maturity well below the USD 9.20 strike price would likely mean that the daily accrual mechanism accrued 260,000 shares for many days. Therefore, if the put was exercised at maturity, the number of unaccrued shares would likely be low.

10.11 OTHER TRANSACTIONS ON TREASURY SHARES

10.11.1 Case Study: ABC's Restructuring of Call on Own Shares

In October 20X1 ABC, a European entity, was considering the exercise of a call option on its own shares that allowed for physical settlement only. The option type was American allowing ABC to exercise the call at any time. The call was purchased in February 20X1 by ABC from Weakbank to take advantage of its low share price. ABC paid a EUR 30 million premium. The call allowed ABC to acquire 70 million of its own shares, representing 7% of ABC's share capital. The expiration date of the American call was 15 April 20X3 and its strike price was EUR 5.00 per share.

In October 20X1, Weakbank's credit rating was downgraded several notches by Moody's and ABC was worried that Weakbank might not be able to meet its obligations under the call. An early exercise was considered, but ABC already owned 8% of its share capital, making the exercise of the call not feasible because it would cause ABC to exceed its 10% legal limit on treasury shares. ABC considered other alternatives, including:

Transaction Implemented by ABC

ABC implemented a transaction split into the following components (see Figure 10.13):

The combination of the call and the put described in 3) and 4) was a “converse”, making sure that at least one of the two options would be exercised. ABC paid to Gigabank a EUR 10 million premium.

Flows upon Exercise

If on exercise date, ABC's share price were above the EUR 9.00 strike price, ABC would exercise the call. The put would automatically expire worthless. Remember that ABC could elect between cash and cash settlement.

• If ABC had the legal authorization to acquire the 50 million ABC shares, ABC would elect physical settlement. Consequently, ABC would acquire from Gigabank 50 million ABC shares and would pay to Gigabank EUR 450 million (= 50 million × 9.00). Therefore, ABC would have acquired 5% of its own share capital.
• If ABC did not have the legal authorization to acquire the 50 million own shares, it would elect cash settlement. Gigabank would then gradually sell the underlying 50 million ABC shares in the market. ABC would receive the difference between the disposal proceeds and the EUR 450 million strike amount. Due to the large period required for the shares disposal, it may cause the disposal proceeds to be lower than the EUR 450 million strike amount. In this case, ABC would pay to Gigabank the difference between those amounts.

If on exercise date ABC's share price were trading below the EUR 9.00 strike price, Gigabank would exercise the put. The call would expire worthless. In this case, ABC would elect between physical and cash settlement. The effects are identical to the two settlement scenarios analyzed when the call was exercised.

Therefore, if ABC elected physical settlement ABC would be acquiring 5% of its own capital at EUR 9.00 per share. If ABC elected cash settlement, ABC would be either receiving or paying the difference between the disposal proceeds and the strike amount.

ABC's Overall Position under the Transaction

From a credit risk point of view, ABC was exposed to Gigabank under the call. If upon exercise ABC's share price was above the EUR 9.00 strike price and ABC chose cash settlement, Gigabank would be required to pay the appreciation of the underlying shares above the EUR 450 million strike amount. ABC could have avoided being exposed to Gigabank by having the bank pledge the underlying shares to ABC. In this case, if Gigabank did not meet its obligations, ABC would take ownership of the pledged shares.

Also from a credit risk standpoint, ABC was exposed to Weakbank until the settlement of the call. This exposure lasted very shortly because ABC exercised Weakbank's call immediately.

From a market risk point of view, ABC was exposed under the put to a fall in its share price below the EUR 9.00 strike price. Conversely, ABC benefited under the call from a share price above the EUR 9.00 strike price. Therefore, ignoring upfront premiums, ABC's position was identical to having bought the underlying shares (see Figure 10.14). In other words, the position from a market risk viewpoint was equivalent to having partially exercised Weakbank's call for 50 million options.

From a cash point of view, ABC's position at inception was positive (see Figure 10.13). ABC paid EUR 350 million to Weakbank, ABC received EUR 450 million from the share sale to Gigabank and ABC paid a EUR 10 premium to Gigabank to enter into the converse. Therefore, combining the two share trades and the converse transaction ABC received EUR 90 million (= 450 mn − 350 mn − 10 mn) in cash.

Gigabank’ Overall Position under the Transaction

From a credit risk point of view Gigabank was exposed to ABC under the put. If upon exercise ABC's share price was below EUR 9.00 strike price and in case of cash settlement, ABC would be required to pay the depreciation of the underlying shares below the EUR 450 million strike amount. In case of physical settlement, ABC would be required to pay the EUR 450 million strike amount. Gigabank could have reduced its exposure to ABC by having the company post cash collateral to Gigabank. In this case, if ABC did not meet its obligations, Gigabank would take ownership of the cash collateral.

Gigabank could have mitigated the credit risk to ABC by structuring the transaction as a pre-paid forward whereby ABC would pay upfront the forward amount. This transaction is equivalent to a collateralized call and put combination in which ABC posts the whole strike amount as collateral to the transaction.

From a market risk point of view, Gigabank’ position was neutral (see Figure 10.15). By owning the underlying shares, Gigabank was exposed to a fall in its share price below the EUR 9.00 acquisition price and participated in the appreciation of the shares above EUR 9.00. This position was fully offset by its exposure to ABC's stock price under the combination of the sold call and the bought put. Under the call Gigabank was exposed to a stock price above the EUR 9.00 strike price. Under the put, Gigabank benefited from a stock price below the EUR 9.00 strike price. Therefore, overall Gigabank was not exposed to ABC's share price.

From a cash point of view, Gigabank's position at inception was negative (see Figure 10.13). By buying the converse underlying shares from ABC, Gigabank had to pay to ABC EUR 450 million. Gigabank received EUR 10 million linked to the converse. As a result, Gigabank had to finance EUR 440 million (= 450 mn − 10 mn).

Legal Considerations

Derivative transactions on treasury shares are a delicate matter. Before signing the agreements, Gigabank had to validate ABC's legal ability to enter into the transaction. To validate it, the transaction legal advisors had to review ABC's articles of association, the approved resolutions of ABC's AGMs/EGMs and the legal rules on treasury shares in ABC's jurisdiction.

Gigabank's initial acquisition of 50 million ABC shares at inception to hedge its market exposure under the converse made it the beneficial owner of the shares. As such, Gigabank was entitled to receive the dividends distributed to the shares and to vote the attached voting rights. However, Gigabank was not exposed to ABC's stock price. In contrast, ABC's overall position was equivalent to a holding of 150 million own shares (100 million shares directly and 50 million under the converse). If ABC held 150 million treasury shares, ABC's shareholders would be entitled to receive the pro rata share of the dividends that in theory corresponded to them and ABC would not be entitled to exercise their attached voting rights. Therefore, if ABC did not receive back from Gigabank any distributed dividends to the shares or if Gigabank exercised its voting rights in a non-neutral way, ABC's other shareholders could be at a disadvantage.

In order to have Gigabank paying back the dividends to ABC, several alternatives could be implemented:

• To have Gigabank to pay back to ABC any dividends received. Under this alternative Gigabank would pay to ABC an amount equal to the product of (i) the strategy delta, (ii) the number of shares and (iii) the dividend per share received by Gigabank. In this case, the strategy delta was 100% at all times;
• To adjust downwards the strikes of the call and the put for any dividends received by Gigabank, and to simultaneously adjust upwards the number of options; or
• To assume a dividend string during the life of the options and to adjust either downwards or upwards the strikes of the call and the put (and their number of options) for any deviation of the realized dividends relative to the assumed dividends. Under this alternative, the premium of the call to be paid by ABC at inception had to be take into account the present value of the assumed dividends.

In order to have Gigabank voting rights a neutral effect in any of ABC's AGMs or EGMs during the life of the transaction, two alternatives could be implemented:

• To not enable Gigabank to exercise its voting rights attached to the shares. In my view, this the most neutral position from a shareholder point of view, if there is enough quorum to vote a certain proposal brought to an AGM/EGM;
• To have Gigabank to do its outmost to participate at any AGM or EGM taking place during the life of the options and to exercise its voting right by voting in favour of the strategic corporate proposals (e.g., the disposal of an asset) submitted and recommended by ABC's board of directors except if Gigabank believed that it was clearly against the interest of the shareholders and voting in favour could trigger shareholder liability of Gigabank. For non strategic matters (e.g., the approval of ABC's financial statements), to have Gigabank to vote in favour or against the proposal at its own discretion. The parties would need to define what matters are considered to be strategic matters. In my view, under this alternative Gigabank may face a conflict of interest if an attractive resolution for the shareholders that has been previously rejected by the board of directors is voted. Gigabank could be afraid of jeopardizing a strong relationship if it votes in favour.

Another important legal element of the transaction was to restrict Gigabank from selling, except as provided for in the call and put agreements, or lending the shares during the life of the options unless an event of default was triggered. This restriction assured ABC that the shares would not be used by other market participants to implement short positions in the stock or to exercise the shares’ voting rights.

In this type of transactions it is common to include a clause in the terms and conditions that protects each party from the other party not meeting its legal disclosure requirements. In this case, Gigabank had to disclose to the stock market regulator the ownership of 5% of ABC's share capital. Regarding ABC's disclosure of the converse, it is usually a grey area. In M&A situations, the parties usually try to avoid disclosing this sort of transactions. In our case, it made sense to disclose the converse transaction. Its disclosure would help investors and research analysts to obtain a better picture of ABC's prospects.

Accounting Considerations

ABC reported under IFRS rules. At inception, the transaction had a positive effect on ABC's equity but it also made ABC's income statement to be exposed to ABC's share price.

Before the transaction, ABC was long Weakbank's call on its own shares. Because the call only allowed for physical settlement, it was treated from an accounting perspective as an equity instrument. As such, the fair value of the option at its inception (i.e., its EUR 30 million premium) was recognized in equity, reducing ABC shareholders’ equity. Additionally, ABC held 80 million own shares at a cost of EUR 560 million (assuming that ABC purchased those shares at an average acquisition price of EUR 7.00 per share), which reduced ABC's equity by this amount. Therefore, before the transaction ABC's equity presented a deduction of EUR 590 million (= 30 mn + 560 mn).

The effects of the transaction were the following:

• The sale of 50 million treasury shares to Gigabank at EUR 9.00 each, increased ABC's equity by EUR 450 million.
• The exercise of Weakbank's call released its original EUR 30 million deduction from equity. However, its exercise caused the acquisition of 70 million own shares at EUR 5.00 each, reducing ABC's equity by EUR 350 million. Thus, the overall negative effect on ABC's equity of the call exercise was a reduction in equity of EUR 320 million (= 350 mn − 30 mn).
• The converse allowed for the election between physical and cash settlement. This provision caused the converse to be treated as a derivative. Thus, ABC was obliged during the life of the converse to fair value it and to recognize the change in fair value in the profit or loss statement. Any increase in the value of its own shares from the previous financial reporting date implied a gain, and conversely, any decrease in the value of its own shares from the previous measurement implied a loss.

As a result of the transaction, ABC released EUR 130 million (= 450 mn − 320 mn) from equity. However, the fair valuing of the converse through profit or loss could increase the volatility of ABC's income statement.

ABC could have avoided the recognition of the converse as a derivative if its options allowed for physical settlement only. This potential solution faced three constraints: (i) the combination of the two instruments could be legally characterized as treasury shares, (ii) ABC wanted to be able to cash settle the transaction in case it did not have the legal permission or the resources to buy back the underlying shares and (iii) from an IFRS point of view, it would require ABC to recognize a liability due to ABC's potential obligation to deliver cash were Gigabank to exercise the put.

10.11.2 Case Study: Gilead's Share Repurchase Program Financed with Convertible Bonds

This real-life case highlights how a company combined a share repurchase program with the issuance of two convertible bonds. The case also shows how Gilead entered into two call spread transactions to reduce the potential dilution of Gilead's common stock upon future conversion of the convertible bonds.

In May 2010 Gilead Sciences Inc. (“Gilead”), a US-based drug maker, announced that its board of directors had authorized a new USD 5 billion share repurchase program through the next three years (i.e., until May 2013), following the completion of a USD 1 billion share buyback program initiated in January 2010. In a statement, Gilead's chairman and chief executive officer, John Martin, said: “Gilead's board of directors and senior management team believe that the stock repurchase program announced today represents an appropriate and strategic use of the company's cash, while allowing sufficient flexibility for other expenditures going forward, including investments in research and development and licensing or partnership opportunities”.

On 30 July 2010, Gilead issued a USD 1.1 billion principal amount convertible senior bond due 1 May 2014. The convertible bond had an initial conversion price of USD 45.04 per share (a 35% conversion premium over the USD 33.39 closing price of Gilead's stock on the day prior to the issue date). The bond paid a semiannual coupon of 1% and could be converted into 24.4 million shares of Gilead's common stock. Simultaneously, Gilead issued another USD 1.1 billion principal amount convertible senior bond, due 1 May 2016. The convertible bond had an initial conversion price of USD 45.41 per share (a 36% conversion premium). The bond paid a semiannual coupon of 1.625% and could be converted into 24.2 million shares of Gilead's common stock. Upon conversion, the bond holders of both convertibles would receive cash up to the principal amount, and any excess conversion value would be settled, at Gilead's election, in cash, common stock or a combination of cash and common stock. Gilead expected to use at least USD 1 billion of the net proceeds from the offerings to repurchase shares of its common stock. The remaining proceeds from the offering were added to Gilead's working capital and were used for general corporate purposes, including additional repurchases of its common stock, and repayment of Gilead's existing indebtedness. The total commission paid to the banks involved in the placement totaled USD 33 million.

In connection with the sale of the convertible bonds, Gilead entered into two call spread transactions with JP Morgan and Goldman Sachs to reduce the potential dilution of Gilead's common stock upon future conversion of the bonds. Gilead acquired the call options embedded in the convertible bonds and sold call warrants to the two investment banks. The bought call option associated with the 2014 convertible had 24.4 million underlying shares, an initial USD 45.04 strike price and a 1 May 2014 expiration date. The bought call option associated with the 2016 convertible had 24.2 million underlying shares, an initial USD 45.41 strike price and expiry in May 2016. The call warrants associated with the 2014 bond had an exercise price of USD 56.762, which was 70% higher than the USD 33.39 closing price of Gilead's stock on the day prior to the issue date, and covered 24.4 million shares. The call warrants associated with the 2016 bond had an exercise price of USD 60.102, which was 80% higher than the USD 33.39 closing price of Gilead's stock on the day prior to the issue date, and covered 24.2 million shares. Gilead paid for the purchased calls an aggregate amount of USD 311.8 million of the proceeds from the sale of the convertible bonds. Gilead received on aggregate a premium of USD 132.5 million from the sale of the warrants.

Figure 10.16 shows the building blocks of the transaction. It can be inferred that the total proceeds from the convertible bond issues and the call spreads were USD 1.988 billion (2,200 million – 312 million + 133 million – 33 million).

To show the flows at maturity, or upon early conversion, I will only cover the 2014 bond. The reasoning for the 2016 bond is similar. There were three potential scenarios:

Final Comments

The acquisition of own shares financed with the issuance of convertible debt is a quick way to leverage the capital structure of the company. In some jurisdictions, it can also be attractive from a tax viewpoint. Interest on the debt is usually tax deductible, while profits on own shares can be tax free in some countries.

In my view, the transaction had two main strengths. Firstly, it allowed Gilead to partially finance the share repurchase, with a low financial cost. Secondly, it allowed Gilead to lock in large profits if the warrants were exercised. As an example, let us assume that Gilead bought back own shares at an average price equal to the USD 33.39 stock price prevailing at inception. An exercise of the call warrants would imply selling the stock at 56.762 (or USD 60.102), a substantial profit. However, it would mean that Gilead had to keep in its balance sheet an equivalent number of shares.

The banks (Goldman Sachs and JP Morgan) selling the call spread needed to acquire shares in the market at inception of the transaction. This buying activity was partially offset by the initial selling from the convertible bond holders. However, if there was a net buying activity, Gilead had to be careful to avoid buying own shares while the two banks put in place their initial hedge. Otherwise, share price could be driven up unnecessarily.