SEC Rule Mandating Share Buyback Disclosure Challenged by Chamber

Stock buybacks are a common, and ever more popular, feature of our financial landscape. In 2022, corporations purchased $1.25 trillion of their own stock. Since 2012, buybacks have almost tripled in value, up 184%. By contrast, dividend growth for the same period, at 54%, lags far behind.

You probably know the pros and cons of the practice. Repurchases offer some significant tax advantages over cash dividends, which require the investor to take the cash and pay tax on the distribution. They boost shareholder value by increasing each owner’s stake as well as earnings per share. Buybacks are also advantageous for corporations, providing as they do a ready currency, the repurchased shares, for acquisitions, and a buyback program can be used to make large-scale changes in a company’s capital structure. Repurchased shares are also widely used to offset earnings per share dilution which result from grants of stock option plans.

On the other hand, companies engaged in buybacks, critics say, focus too much on the near term and are detrimental to long-term value in that they divert funds from investments in research and development and technology and may deprive companies of extra liquidity needed in downturns. Critics also charge that buybacks allow corporations to create the illusion of higher earnings without actually increasing profits. Others have suggested buybacks can also be a vehicle for market manipulation and are nothing more than insider trading in disguise.

Our purpose is not to settle this debate (as if we could). The probability that share repurchases are going away is pretty slim.

The Securities and Exchange Commission addressed another criticism of buyback programs, the lack of transparency, in a rule, entitled Share Repurchase Disclosure Modernization, designed to enhance disclosure of information related to the repurchase by companies of their equity securities. The regulation went into effect on May 5, 2023.[1]

According to the SEC, the rule was designed to enhance the transparency and integrity of the buyback process in two ways: first, by providing information connected with corporate share repurchase activities; and second, by requiring that companies disclose the rationale for the repurchases. According to the statement of SEC Chair Gary Gensler accompanying publication of the rule, these measures will enable investors to better assess the value of buyback programs and thereby make more informed decisions. While he did not mention insider trading, the Chair contended that the “disclosure will also help lessen some of the information asymmetries inherent between issuers and investors in buybacks.”

The SEC rule requires that issuers disclose share repurchase dates in their quarterly or semi-annual reports as well as the number of shares purchased, the average purchase price, the objective of the buybacks and the process for determining the number of shares repurchased. Issuers are required as well to disclose policies related to buybacks, whether executives traded within four days of the commencement of the buybacks and if the purchases were for purposes related to a 10b5 plan. A 10b5 plan is a trading plan which allows corporate insiders to schedule trades in the company’s stock under designated parameters. Such a plan is not mandatory, but may be used as a defense to a charge of insider trading.

It didn’t take long for the filing of a legal challenge to the rule. A consortium of business advocacy groups, led by the United States Chamber of Commerce, filed a Petition for Review in the Fifth Circuit Court of Appeals on May 16, 2023.[2] The consortium includes Texas business associations, which permitted filing in the Fifth Circuit, a court with a history of hostility to federal regulation. While the filing does not specify any grounds for the challenge, a Chamber of Commerce press release argues that the regulation discourages buybacks, risks public airing of managerial decisions and violates the First Amendment rights of corporations.

There doesn’t seem to be much chance that the regulation will mandate disclosure of closely-held corporate secrets. It’s predominantly informational. And if the rule discourages a buyback because the company wouldn’t, or couldn’t, offer a rationale for the action, maybe that isn’t a bad thing. The free speech argument, however, bears further examination.

The issue projected is whether the government-mandated disclosure, which constitutes commercial speech, of a statement that the corporation would care to avoid is protected by the First Amendment. To prevail, the SEC needs to satisfy a three-pronged test the United States Supreme Court announced in Central Hudson Corp. v. Public Serv. Comm’n, by showing that: (i) the compelled disclosure satisfies a substantial governmental interest; (ii) which is directly advanced by the disclosure; and (ii) the restriction is narrowly tailored.[3] Put otherwise, the rule must address an important policy objective, and the governmental interest motivating the compelled disclosure must be based upon facts, not mere speculation.

It's a test another SEC rule failed in a National Ass’n of Manufacturers v. SEC[4], a challenge to a law and an SEC regulation concerning disclosure of “conflict minerals.” In adopting the rule, the SEC was attempting to address the humanitarian catastrophe caused by civil war in the Democratic Republic of the Congo. Armed groups financed the conflict largely by extorting, and in some cases directly managing, lightly regulated mining operations in the Congo. The Dodd-Frank Wall Street Reform and Consumer Protection Act required the SEC to promulgate regulations requiring that firms investigate and disclose their use of conflict minerals “necessary to the functionality or production of a product.”[5] The object of the rule was to reduce violence and provide peace and stability in the Congo.

The rule failed to satisfy the Central Hudson standards because its benefits were speculative. The SEC was unable to present evidence that the compelled disclosure would have any impact on the civil wars playing out in the Congo. As a result, the Court of Appeals held that the section of Dodd-Frank and the SEC’s rule mandating the disclosure constituted compelled commercial speech in violation of the First Amendment.

The SEC’s buyback rule mandates mainly disclosure of facts, and is consistent with the logic behind the federal securities laws that investors are entitled to know all material information about the companies in which they are considering investing in order to make sound decisions. It’s an approach that has been tested over decades under laws which compel considerably more disclosure than the share repurchase regulation. The share buyback rule’s goal of investor protection is precisely what virtually all SEC rules compelling disclosure strive to achieve. It’s also quite unlike a requirement that a corporation report on the use of conflict minerals to reduce violence in a foreign civil war where there was no available evidence to prove the rule would serve that purpose.

The Chamber of Commerce might get a high grade for creativity, but it’s probably not going to get the litigation result it wants.

[1] See SEC Release No. 34-97424. The rule will be codified in Parts 229, 232, 246, 249 and 274 of Title 17 of the Code of Federal Regulations. The initial filing will cover a corporation’s first full fiscal quarter beginning on or after October 1, 2023. [2] Chamber of Commerce of the USA v. SEC, Case No. 23-60255 (5th Cir. filed May 16, 2023). [3] 447 U.S. 557 (1980). [4] 800 F.3rd 518 (D.C. Cir. 2015). [5]15 U.S.C. §78m(p).